Balancing the Mission Checkbook

Right now, about 25% of the nonprofits that we are working with pretty closely are in the midst of a capital campaign, are just finishing their campaign, or have plans to launch one in the next year or so. The meaning of “capital” campaign is evolving, and about one-third of these campaigns include a substantial amount of flexible working capital and infrastructure investment in addition to traditional bricks and mortar. (This is an important trend that I’ve written about before.) Looking at the campaigns and organizations as a whole, it’s clear that the campaigns that are going well were thoughtfully planned out, based on feasibility studies, and focused on donors with whom the nonprofit already had a relationship. The campaigns that have floundered or dragged on were based on some broad assumptions about who “should” support them, plugged numbers to fill out the budget, and the planning happened along the way. These observations lead right to the basics of capital campaigns – lots of planning, being realistic, committing the time and people, and monitoring everything as you progress.

Capital campaigns also demand consideration of external factors, including the competitive impact of other capital campaigns and of economic trends. We in Minnesota can thank the Minnesota Council on Foundations for conducting a survey last month on Capital and Endowment Campaigns in Minnesota, 2007-2008. The survey reports on 62 current and 72 planned campaigns for buildings, endowments, and infrastructure investments. The largest campaigns are for colleges and universities, with human services and health care a distant second and third. Interestingly, the higher ed, health care, and arts organizations expect most of their funds to come from individuals donors, while human service nonprofits expect about half to come from grants. This week’s Chronicle of Philanthropy reports in “Feeling the Squeeze” that some large capital campaigns are running into some resistance from large donors concerned about the economy. The examples in the article, which is only available in its online format to subscribers, indicated that gifts were delayed or stretched out, but that the campaigns continued to be successful in a different environment.

If you are beginning to plan a new fundraising push – whether you call it capital campaign or not – you need to understand the trends, the local landscape, and how many other “asks” will be in the mail.

The State of Vermont recently adopted legislation creating a new type of entity, a Low-profit Limited Liability Corporation. The L3C, as it is called, is sort of a hybrid of for-profit and nonprofit created as a way to attract both private and philanthropic capital to build businesses with a social benefit. The leading advocate for this new structure has been Americans for Community Development and the Mannweiler Foundation.

The idea behind this hybrid, from an excellent overview of the L3C written by Americans for Community Development, is to “access the vast pools of market driven wealth to make socially responsible investments in so called nonprofit areas.”

From what I understand, the L3C is formed as a Limited Liability Corporation, a well established and flexible business form. The members, or shareholders, of an LLC are entitled to receive a profit or return on their investment. The nonprofit-like aspect comes in the “low-profit” name. The Vermont legislation requires that the L3C must also meet these requirements:

• “Significantly furthers the accomplishment of one or more charitable or educational purposes”
• “No significant purpose of the company is the production of income or the appreciation of property”
• “No purpose of the company is to accomplish one or more political or legislative purposes”
• The name of the company “shall contain the abbreviation L3C or l3c”

This language was carefully developed to qualify these new entities to receive investments from foundations through Program Related Investments. I’ve written before about PRIs as an interesting and unique source of capital funds for nonprofits.

“The key insight of the L3C is that it is not a two-part world but a three part world and that many worthy causes are capable of being self sufficient; they simply do not offer enough of a return in order to attract for profit investors - particularly at their inception,” (Americans for Community Development). So the idea is to create businesses that can attract some private capital, bolster that with more patient philanthropic or socially motivated investment, and result in value to the community (jobs, housing, local revitalization) and a below-market return to investors. This structure is not a fit for every nonprofit, or even for every social enterprise. The L3C is all about raising capital, and when the need for capital is significant, this is worth considering. While the legal form currently exists only in Vermont, several other states are considering adopting the enabling legislation. Meanwhile, an L3C formed in Vermont can operate in any state.

For more information about the forces that are driving the demand for an alternative structure, and some arguments that a new form are unnecessary, The Aspen Institute published a report last year by Thomas Billitteri, Mixing Mission and Business: Does Social Enterprise Need a New Legal Approach?

Call it what you want – surplus, positive change in net assets, or profit – nonprofit organizations really need to plan for, and embrace, the importance of building financial capacity by generating a cushion. We don’t have a common language for this, and many nonprofit leaders would be uncomfortable using a term like “profit” when describing their financial goals. The word is much less important than the practice of budgeting and managing to build surpluses. Read “Organizational Slack (or Goldilocks and the Three Budgets” by Woods Bowman, published in the Spring 2007 issue of The Nonprofit Quarterly, for a very helpful overview of the topic.

The definition of slack used by Bowman is “a cushion of potential resources which allow an organization to adapt to internal pressures for changes in policy, as well as to initiate changes in strategy with respect to the external environment.” The benefit of a cushion is probably clear to any nonprofit director. Money doesn’t just fall into your lap to build a reserve. Bowman makes it simple and direct: “Where does financial capacity come from? There can be only one place: annual surpluses.”

Planning for an annual surplus, specifically an unrestricted surplus, is a positive, important, beneficial, and necessary practice for all nonprofits. I emphasize the importance of viewing unrestricted operating results, rather than the total of all unrestricted and restricted funds, because of the volatility in results caused by the timing of project and multi-year grants.

One step that could encourage the practice is to add a measure or ratio that defines the annual addition to the reserve or cushion. In the for-profit world, this is communicated in a fundamental ratio:

Net Operating Income = Profitability Ratio
Total Sales, or Revenue

The comparable measure for a nonprofit could be a CINA (change in net assets) ratio:

Unrestricted Change in Net Assets = CINA Ratio
Total Unrestricted Income

Try calculating this ratio for your nonprofit organization for the past few years and you will start to see how well the ratio can communicate the building, or depleting, of financial capacity. How high should the ratio be? On this point a for-profit and nonprofit organization will differ. A for-profit company seeks the highest ratio possible. For a nonprofit the ideal amount of surplus depends on what they need – and that balancing act is complicated. Bowman’s article has a whole section on measuring the right amount of slack needed.

I teach a graduate class in Financial Management for Nonprofit Organizations at Hamline University in Saint Paul. This week’s class topic was social enterprise, nonprofit business start-up, and earned income strategies. One of the hurdles the class faced was with the terminology and definitions used in the “field” of social enterprise. The question that came up again and again is this: what’s the difference between “social enterprise” and ordinary, everyday program activities that have a fee for service or a price attached? I stumble over this question myself. On the one hand, we could say that it doesn’t really matter what terms we use to describe the different earned income streams for a nonprofit, but I think that the continual banging of the “social enterprise” drum make it important to face this question. Case in point: theaters generate earned income by selling tickets to audience members. When the same theater sets up a little business renting out the dark theater during the day for corporate events, they are suddenly recognized as a “social enterprise.” What about all those ticket sales?

In the FAQ section of the Social Enterprise Alliance, social enterprise is defined as “any nonprofit business, venture, activity or strategy conducted for the purpose of generating earned income in support of a social mission.” That definition would seem to include all earned income, from the ongoing theater ticket sales and community clinic’s patient fees to the start-up catering business of a daycare center or corporate events at the theater. If you read the books, articles, and research studies about social enterprise, though, you will see a distinct emphasis on the latter type of revenue – something new and different, rather than something tried and true. The Social Enterprise Alliance also has a nice article on this topic, Social Enterprise: Hype or Reality, which acknowledges that earned income has been a part of the income mix in the nonprofit world for years. The newness of these strategies may be more noticeable in social service agencies than in the arts, health care, or community development. This “new” field might be more about the importance of paying attention to the value of earned – and therefore unrestricted – income, as well as taking steps to generate earned income on purpose and purposefully.

The field of social enterprise, however you define it, is certainly well documented and analyzed. In addition to Social Enterprise Alliance, you will find interesting information and research from REDF and Community Wealth Ventures. If you want an in-depth study with lots of cases, read Community Wealth Venture’s report, Powering Social Change.

What do you think – is social enterprise a distinct and definable movement among nonprofits, or is it a just a new name?

Imagine this, the development director rushes in to interrupt a board meeting with the news that you have just received an unexpected, and unrestricted, gift of $50,000. How would the management and board decide how to use the new funds? (Assume for this little exercise – or fantasy, if you prefer – that your annual budget is balanced and you have sufficient cash flow to pay the bills.) For many nonprofits, there would be no doubt about it – every cent of the $50,000 would be used as soon as possible to serve as many people as possible. A homeless shelter would add more beds, a youth center would expand a program, and a clinic would increase free clinic hours. For many members of the board and staff, the decision seems simple and obvious – in the face of so much need out there, how could you not spend the money to increase services?

The long-term result of this way of approaching financial management is what Elizabeth Keating calls the “Current Services Trap.” By using all available resources to meet urgent, short-term needs, nonprofit organizations undermine their long-term stability and viability. Keating described the trap and accompanying organizational and financial characteristics at the Capital Ideas Symposium that was presented earlier this year by the Hauser Center and the Nonprofit Finance Fund. Keating’s article is printed on pages 11 – 16 of the full proceedings – it’s worth reading!

I agree with her basic premise that nonprofits and funders must understand the importance of building infrastructure, cash reserves, professional staff, and appropriate capital to support their mission. One of the toughest things to do, though, is to make the case for these investments in nonprofits, and Keating lays the groundwork for us by describing what she calls the three myths that sustain the current services trap. The myths include the notion that nonprofits address urgent needs that can be solved quickly if we have enough funding. This assumes that providing more services would be (a) easy to do, and (b) would solve the problems. But would homelessness really be “solved” by adding more beds to a shelter? The problems that nonprofits address are complex, difficult, and much bigger than a simple service. To break out of the Current Services Trap, our hypothetical nonprofit board would need to consider ways to use the windfall gift to build infrastructure, innovation, technology, and human capital. The payoff will multiply.

I read a great example of this kind of breaking out of the trap in the November 7, 2007 StarTribune story, Can Metro-Area Hunger be Eliminated in Five Years? Five Twin Cities food shelf organizations are working together to move beyond providing groceries today, so that they also address the bigger problems the cause their clients to need services. “Instead of trying to incrementally reduce hunger bit by bit, these groups want to reorganize the way food shelves work, with the goal of ending hunger altogether in the metro area by 2013.” There wasn’t a budget included, but you can be sure that this will take a lot more than funds for current services – this would require investment in long term planning, infrastructure, fundraising, staff, and communications. It’s a great case study for the future.

One of the hidden gems in foundation grant guidelines is a type of funding that is too often overlooked. Program-related investments (PRI) are essentially loans from a foundation, but with terms that are very flexible and preferential. PRIs are a great option for nonprofits that are able to generate cash in the future from capital campaigns or program income. The name program-related investment refers to the requirement in IRS rules that PRIs must be primarily intended to serve the foundation’s charitable mission rather than to generate market-rate income. Because of this requirement, PRIs usually have low interest rates, few fees, and no requirement for collateral. The foundations do evaluate both program plans and financial information carefully for quality of planning and repayment ability. To learn more about PRIs, read the resources available from the PRI Makers Network or the guide from Grantcraft.

An example of a good use of a PRI is an organization that received a $250,000 PRI to renovate a building to expand their jobs training program. Because the program generates program income from the sale of furniture built by the participants, they have the ability to repay a PRI over a period of time. While a capital campaign for the renovation would have been great, the time and expense would have slowed down the project unnecessarily. A PRI application was submitted and approved within a few months compared to the year or so required for the fundraising effort.

Between 1990 and 2001, US foundations advanced 2,900 PRIs totaling $1.7 billion. PRIs are used by nonprofits in all fields, dominated by community development organizations. Nonprofits Assistance Fund, for example, uses PRIs as a source of capital for our loan funds. The foundations that have been most active in PRI funding include the John & Catherine T. MacArthur Foundation, The Ford Foundation, and Minnesota’s own Otto Bremer Foundation. There is growing interest from other foundations of all sizes in learning more about PRIs and developing PRI programs in their grantmaking.