In many nonprofits, a time comes when the question arises: should the organization accept personal loans from board members? This article does not try to answer that question. It does try to outline — very briefly — some of the choices in how such loans can be made. Use this article as a starting point for a discussion with the board or a discussion with your personal financial advisor.
Board members have often lent crucial funds to their organizations, making it possible to get through a temporary cash shortage or get started on a new venture, and have been paid back promptly. But there are also examples in which loans from board members have led to resentments and accusations, and the loans are not repaid to some or all of the board members. In short: a loan from a board member is a risky venture.
This article discusses six types of loans from board members: unsecured loans, secured loans, guaranteeing a loan or line of credit, pooled loans, floating endowments, and issuance of bonds.
For any of the types of loans discussed here, be sure to do the following:
- Have legal documents drawn up and reviewed by an attorney for the organization. In addition, each board member lending money should have the documents reviewed by his or her own lawyer or financial advisor.
- The board should formally vote to accept any loans from board members and approve the terms of such loans, and any board members lending money should be excused from the vote.
- If all or the majority of board members are lending money, the loans and the legal documents should be accepted by roll-call vote of the board and recorded in the minutes.
- Make sure the lending board members understand that in bankruptcy or liquidation, lenders who are board members are considered “insiders” whose loans may be “subordinated” — pushed down to the last in line for payment. Among reasons for subordination: perceived board mismanagement of the organization.
Very importantly, discussions and decision making are likely to be influenced by loans from board members. Board members who have lent more than others may feel their opinions are more important as they are the most financially at risk. Others who may not have lent money tend to defer to those who have. Disagreements that were once spirited can become bad-tempered and disruptive.
1. Unsecured loans
In a nutshell: An individual board member (or several board members) lends money to the organization without collateral.
Example: Each of five board members individually agrees to make unsecured loans of $5,000 each, at no interest, to be paid back within 120 days.
Be sure to:
Execute (draw up and sign) a loan document for each loan that specifies the amount, the interest due on the loan (if any), when the loan will be paid back (in installments or all at once), and what recourse (if any) the lender has if the loan is not paid back on time.
- For the organization: unsecured loans are fast and uncomplicated, particularly for small amounts of money.
- For board members: do not lend more than you could easily afford to lose.
- Failure to repay the loans will likely be resented by board members who have lent money.
- If the organization closes and goes bankrupt, other creditors (such as the landlord, the copier lease company) will be repaid before unsecured loans.
- In some cases, individuals who have made loans may feel that their opinions are weightier than those who have not, and board decision-making processes may be disrupted.
2. Secured loans
In a nutshell: An individual board member (or several board members) lends funds to the organization to be paid from a specific anticipated income, or secured by specific assets of the organization.
a. Before the annual luncheon fundraiser, a board member lends $3,500 to the organization with the agreement that he will be the first creditor repaid from the gross receipts of the luncheon.
b. Two board members each lend the organization $25,000 with the parking lot (which is fully owned) as collateral.
- Because secured loans are “backed up,” lenders may feel more confident they will be repaid and, as a result, may be willing to make loans, larger loans, or loans at lower interest rates.
- On the other hand, an organization can lose an important asset over a relatively minor loan.
Be sure to:
- Act with a great deal of caution when considering secured loans.
- Do not use a large asset (such as a building) to secure a small loan.
3. Guaranteeing a loan or line of credit
In a nutshell: The organization approaches a bank for a line of credit or a term loan, which is guaranteed by (co-signed by) a board member.
Example: A bank gives the organization a line of credit for up to $10,000 and an individual board member agrees to repay the loan if the organization defaults on repayment.
- A line of credit allows the organization to borrow funds as it needs them, up to a limit allowed by the bank. This method permits a board member to help without actually laying out cash (assuming the bank loan is eventually repaid).
- It’s easy for disputes to arise if an organization has funds in other accounts but refuses to repay the line of credit or has made decisions deemed unwise by the board member making the guarantee.
- In the event of bankruptcy, the guaranteeing board member may have to honor the guarantee at a time when there is no prospect of repayment from the organization.
- A board member’s guarantee can be secured by a pledge of collateral, just as in a secured loan.
4. Pooled loan
In a nutshell: A number of board members place $10,000 into a pooled bank account. Two board members lend $2,500 each (or 25 percent each of the total), and five board members lend $1,000 each (or 10 percent each of the total). The organization can use funds from this account, using any one of the three options listed above. If, at the time agreed upon for repayment, there is not enough money to repay the board members, the amount available is repaid proportionately. In this instance, if there were only $2,000 for repayment, each of the first two board members would get $500 back (25 percent of $2,000), and each of the five other board members would get $200 back (10 percent of $2,000).
Comment: This arrangement allows all board members to share in the risk, rather than having to decide which board member would get repaid first, second, and so on.
Be sure to:
Have signed loan documents that specify:
- whether the loaned funds will be used directly or to guarantee other loans,
- the interest rate and interest payment schedule (if any),
- dates for payment(s), and
- recourse, if any, that board members have in the event of a loan default.
5. A “floating endowment”
In a nutshell: Most often used by private schools, board members (or parents whose children are in the school) make unsecured loans to the organization for a specified period of time.
Example: At the time of a child’s enrollment in the school, his or her parents are required (or strongly encouraged) to make a loan to the school of $2,000, at no interest, which is repaid to the parents at the time the child leaves the school. These loaned funds are held in a special account and used to guarantee the line of credit obtained by the school.
- In a way that parents or board members may find relatively painless, the organization has the ability to obtain a significant line of credit.
- Craft the arrangement so that, if departing parents can’t be fully repaid, all parents (not just those departing that year) share the burden.
- The requirement to help with a floating endowment can be much more difficult to bear for some parents than for others.
6. Issuing a bond
In a nutshell: A nonprofit can issue bonds to board members and members as a way of borrowing funds from those same people. Typically there is more risk to these bonds than those available on the open market, but members, board members, and others may be willing to accept this higher level of risk in order to raise funds for a large investment such as a new wing. In addition, nonprofits can issue tax-exempt bonds through government entities (a city, for example). In such a case, the organization — let’s say a local museum or YMCA — issues a tax-exempt bond and sells the bonds to the public. (The bond is usually not worth doing unless the bond is for more than $2 million). The bond is paid back with interest over a number of years (ten or more) with funds earned in the future.
(Note: a common but mistaken belief is that bonds must be approved by elections. This is true for some bonds, but revenue-based bonds for nonprofits can be issued as above without a public vote.)
- Bonds are complex transactions that many people feel they cannot understand.
- Issuing a bond requires expert legal and banking assistance. You may have a volunteer parent or board member with such expertise, but be sure to get an outside opinion as well.
This article only describes some ways that loans can be made and accepted. Perhaps a more important question is whether loans from board members or others are appropriate at all. If an organization is in serious financial trouble, it’s unlikely that loaned monies will help solve the problems. (And consider how difficult it might be, in a last ditch effort, to try to raise money to pay back board members.) On the other hand, if an organization is waiting for a guaranteed payment in the future, or if the board members are willing to make personal investments in the organization, loans can help an organization get through a temporary difficulty to a brighter future.
Thanks to Paul Rosenstiel of E. J. De La Rosa Investment Bankers for assistance with this article.
Jan Masaoka is Editor of Blue Avocado. This article is based on her years of finance consulting to nonprofits, and is adapted from a section in The Best of the Board Cafe, which compiles dozens of Board Cafe columns about nonprofit boards.