Board Cafe: Loans From Board Members

Board Cafe

Loans From Board Members

By Jan Masaoka

With the extended economic slump, many nonprofits are suffering from a “perfect storm”—major cuts in government funds, the disappearance of corporate gifts, smaller and fewer foundation grants, and even declines in individual donations.  As times get tougher, more boards are considering whether they should ask their members to make loans to the organization.  This month’s Main Course article responds to a situation faced by many Board Café readers.  Please note that because each situation is unique, this article does NOT discuss whether or not to accept loans, but rather the various ways such loans can be structured.  

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 on the board or a discussion with your personal financial advisor.

There are many examples where board members have lent crucial funds to their organizations that have made it possible to get through a temporary cash shortage or get started on a new venture, and where those board members have been paid back promptly.  But there are also examples where loans from board members have led to resentments and accusations, where loans are not repaid to some or all of the board members who made loans.  In short: a loan from a board member is a risky venture.  

For ANY of the options below, be sure to:

  • Have legal documents drawn up and reviewed by an attorney for the organization.  Each board member lending money should have the documents reviewed by his or her own lawyer or financial advisor.
  • If only a few board members are lending money, the board, having excused those board members from the discussion and vote, should formally vote to accept such loans.  
  • 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, 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 – for reasons such as perceived board mismanagement of the organization.

Remember that discussions and decision-making are likely to be influenced by loans from board members.  A board member who has lent more than others may feel her opinion is more important as she has 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) loans 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.

Comment: For the organization: unsecured loans are fast and uncomplicated, particularly for small amounts of money.  · For board members:  do not lend more money than you could easily afford to lose.  Risks: Failure to repay the loan will likely be resented by the board member.  · If the organization closes and goes bankrupt, other creditors (such as the landlord, the copier lease company) will be repaid before unsecured loans are.  · 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.

Examples:  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.

Comment:  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 or 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.

Comment:  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 “2” above.

4. Pooled loan

In a nutshell:  A number of board members place funds into a pooled bank account, such as two board members lending $10,000 each, and three board members lending $2,500 each, making for a total of $27,500 in the account.  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 $3,500 for repayment, each of the first two board members would get $1,000 back, and each of the three other board members would get $500 back. 

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, etc. 

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. 

Comment: 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—usually not worth doing unless the bond is for more than $2 million—is paid back with interest over a number of years (ten or more) with funds earned in the future.

Comment:  Bonds are complex transactions that many people feel they cannot understand. Issuing a bond requires expert legal and banking assistance.  If you have a volunteer parent or board member with such expertise, be sure to get an outside opinion as well.

REMEMBER: 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, 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 where a bright future can be built.

Special thanks to investment banker Paul Rosenstiel of E.J. De La Rosa for assistance with this article.

Original publication date: 1/23/2003

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