Balancing the Mission Checkbook

Three cheers, at least, are deserved for Grantmakers for Effective Organizations (GEO) new publication On the Money by Nancy Burd. You can download either the executive summary or full report from the website.

As summarized on the GEO website:

This publication highlights the financial challenges nonprofits face and the ways in which grantmakers are both improving the situation as well as perpetuating the problem.

The first section, Assessing the Problems, identifies five problem areas:

1. Restrictions on Funding
2. Misperceptions Around Sustainability and Growth
3. “Too Many Masters”
4. Onerous Grantmaking Practices
5. Knowledge Gaps

The other sections discuss Barriers to Smarter Grantmaking and Ideas for Grantmakers.

It’s impressive how in 28 pages the author distills a variety of ideas, research, and practices about the realities of financial instability faced by nonprofits. The report also provides helpful and realistic suggestions for grantmaking organizations based on practices that have already been developed and implemented by foundations.  The advice and guidance for funders is great, but this guidebook is a must read for everyone in our sector.

I’m pleased that GEO will be focusing on nonprofit finance and encouraging foundations to understand how “many prevailing approaches and practices in philanthropy can unwittingly create problems for the nonprofit sector.” Many nonprofits have experienced these unintended consequences and will welcome a dialogue on this topic.

However, nonprofit organizations also have a lot to learn from the report’s comprehensive overview of grantmaking. Misconceptions about the true cost of programs and capital needs apply equally (or more) at many nonprofits. We can’t expect a seismic shift in foundation practices and investment unless we nonprofit leaders understand and can effectively communicate what it takes to sustain ourselves.

Download this report, read it, and copy it for your board and senior staff.

Last week I had the pleasure to participate in the final round of judging for the Minnesota Cup business plan competition, “looking for the next great entrepreneurial success story in our state.” The judges finished the afternoon of presentations from the six impressive finalists with some discussion about the strengths and weaknesses of the business plans. Everyone agreed that all of the ideas were innovative and had great market potential. Most of the questions boiled down to execution – did they have the right people beyond the founder, would they be able to build the kinds of systems and structures they would need, would they have enough capital to spend to build the systems? The judges understood that breakthrough ideas are only as good as the follow through and structure to make them happen. The day ended with a well attended event and announcement of the winning business plan.  Each finalist won some seed funding and pro bono professional services for prevailing at the division level and the grand prize included more seed funding to implement the plan.

What a stark contrast, then, to read The Bridgespan Group’s recent article The Nonprofit Starvation Cycle about the causes and consequences of weak infrastructure at many nonprofits:

Organizations that build robust infrastructure—which includes sturdy information technology systems, financial systems, skills training, fundraising processes, and other essential overhead—are more likely to succeed than those that do not. This is not news, and nonprofits are no exception to the rule.

The judges for the Minnesota Cup business plan competition certainly know this about business. But what would be the questions raised by a corollary panel reviewing nonprofit plans? Unfortunately, I think they would focus on overhead ratios rather than the importance of having the right systems, structure, and technology to implement the plans, along with sufficient operations and finance staff. The infrastructure that’s encouraged for growing business is overlooked (or undermined) for nonprofits.

The Bridgespan Group believes that this starvation cycle begins with funders:

Our research reveals that a vicious cycle fuels the persistent underfunding of overhead. The first step in the cycle is funders’ unrealistic expectations about how much it costs to run a nonprofit. At the second step, nonprofits feel pressure to conform to funders’ unrealistic expectations. At the third step, nonprofits respond to this pressure in two ways: They spend too little on overhead, and they underreport their expenditures on tax forms and in fundraising materials. This underspending and underreporting in turn perpetuates funders’ unrealistic expectations. Over time, funders expect grantees to do more and more with less and less—a cycle that slowly starves nonprofits.

I think that the authors describe the cycle perfectly, but you could replace the word “funders” with “boards of directors” or several other nonprofit stakeholders just as accurately. The burden of breaking the starvation cycle is shared and will require us to understand the real value of infrastructure in accomplishing mission. Start with this question: what could you achieve in the community if your organization had the structure – systems, facilities, processes, staff - that were needed for long term success? What would you need to make that happen, and how much would it cost?  For the entrepreneurs at the Minnesota Cup, their potential investors understand the importance of seed funding to build the staff and systems needed for success. We in the nonprofit world need to learn the language and incentives to advocate for infrastructure funding critical for community success.

Is it puppy love or the real thing?

The Low-profit limited-liability company (L3C) structure is attracting attention and commentary about a new way to solve community problems using market-driven practices. The idea of a “new model” is so alluring, though, that I see misunderstanding and lots of hopeful thinking. I like the structure and give lots of credit for innovation and perseverance for its creation and growth to Americans for Community Development. My concern is that the L3C is being discussed by nonprofits and businesses as a single solution to some complex problems. It isn’t.

As described in ACD’s FAQS, the L3C structure is a viable approach to attracting capital with lower than market returns and a social mission. It is not, however, a solution to nonprofit or business entities that have expenses that are higher than revenue (that’s called a deficit in both worlds). It is also not a solution to a business or nonprofit that is losing its market, audience, donors, or other revenue sources.

In this recent article in The Chicago Tribune, for example, one of the cases offered is instructive:

Social entrepreneur Mike Melillo of Watchung, N.J., hopes to secure foundation funds for his social media company by converting the LLC to an L3C. He launched SocialChord, which provides local online communities, with the intention of bringing in investors. Despite two years of trying, Melillo hasn’t nabbed the capital he was counting on. Without the L3C structure to potentially open a new funding stream, Melillo said, “at this point, I’d probably just fold.”

In this case I would want more information about the ongoing business (revenues, expenses, market potentials) before agreeing that the L3C structure brings instant relief.

The allure of the L3C has been problematic for nonprofits as well. Most nonprofits require ingoing contributed funds (individuals, foundations, events) to pay annual expenses to deliver programs and services. These donors generally expect to give to an organization with IRS tax-exempt status. The L3C structure won’t satisfy this requirement - it is developed to attract capital but not tax-deductible, contributed funds. I can think of a few (but only a few) nonprofits that only require low cost, patient capital to support their mission.

Jeff Texler recently questioned whether the L3C structure was really needed by nonprofits in a blog post on JustMeans.

I say all this not to discourage anyone from forming an L3C or advocating for a similar statute in their own state. Rather, my aim is simply to provide a needed reality check. Based on the experience of another standardized social benefit form - the UK’s CIC - the L3C is likely to be no more a magnet for investment and revenue than any other kind of business. In fact, it might even prove to be less successful, since most investors won’t know what it is. Rather than simply dreaming about how the L3C could solve your organization’s money problems, you should also look into what is already possible.

I think his point is important for nonprofits that have fallen in love with the idea of a “new model.” I recently read this online post: “I would like to form an L3C to provide housing and services to various special populations …” First, I’d be interested to know why the 501c3 structure wouldn’t work for this proposed entity. Second, I wonder if the L3C would serve this mission at all. Is this a capital need, or will ongoing support be needed?

Structure should always follow purpose and goals, not lead the way. While the booklet If the Shoe Fits published by REDF was published before the L3C existed, it’s a great primer for the questions to ask before you let the excitement of a new idea outpace the needs of the organization.

Worrying about cash shortfalls is, without a doubt, at the top of the list of stressors for nonprofit directors and finance managers. In this situation, everyone’s dream is to have a stash of cash - a cash reserve account set aside to tap at a moment’s notice to solve the problem. I’m reluctant to endorse a universal standard for reserves, but there are “rules of thumb” and accepted practices calling for nonprofits to hold reserves of three to six months of operating expenses. Well it turns out that this “best practice” is a practice in theory only for many nonprofits.

A study by the Urban Institute, reported in the Washington Post this week, Nonprofits Imperiled By Low Reserves found that 57% of the Washington area nonprofits studies had less than three months of reserves, and 28% had none. The June 2009 Nonprofit Current Conditions Report published by Minnesota Council of Nonprofits found new cash flow concerns caused by slower payments from county and state agencies. Surveys in Minnesota have found that at least 35% of nonprofits anticipate cash flow problems this year and 30% have one month or less of operating reserves. Low reserves and cash flow problems are not restricted to small or struggling nonprofits - it’s a widespread management challenge. The Urban Institute study contained an interesting finding, according to the Post article:

According to the study, larger groups were less likely to have sufficient operating reserves than smaller ones, a finding that surprised researchers. Seventy percent of charities with expenses over $5 million had low operating reserves, compared with 50 percent of groups with less than $100,000 in expenses.

This shouldn’t be that surprising when you do the arithmetic. Imagine that you run a nonprofit with an $8 million annual budget. Maintaining a three month reserve would require a $2 million cash account. That’s (a) a big number and (b) very difficult to build up in the low surplus, service delivery model of most nonprofits. Rather than dwelling on the best practice or target for designated cash reserve accounts, maybe nonprofits need to learn to be more sophisticated managers of cash and its relative, working capital. This financial concept was described well by Ben Cameron of the Doris Duke Charitable Foundation last week in a Chronicle of Philanthropy live online discussion, The Changing Role of Foundations.

Ben Cameron:
Most businesses recognize the need for ongoing working capital–it’s the heart of funds that allow a business to make strategic decisions around launching a new program or line of business, investing in a new facility, etc. I have been in discussions with some business executives who have been adamantly opposed to general operating support for arts organizations–thinking it gives organizations free license to be unstrategic and undisciplined–but instantly supportive of flexible working capital. In essence, the purposes are the same–the difference is in how the two terms are heard.

I’ve been advocating for better understanding of Nonprofit Capital for years. In the “nonprofits should be like business” debate, this is the one area where we do have a lot to learn. There aren’t many businesses that strive to hold a three month cash reserve account. That would be viewed poorly, in fact, because it’s an inefficient use of capital.

For peek at how the very largest and most sophisticated nonprofits solve a cash flow problem, read about how Dartmouth Joins Harvard, Princeton in Tapping Credit Markets. Because of the drop in endowments, Bloomberg reported that Dartmouth College just issued $250 million of 10-year notes “for liquidity and general working capital,” according to Julie Dolan, associate vice-president for fiscal affairs at Dartmouth.

Learn to love these words: Working Capital.

For years I’ve wished that the programs of the Small Business Administration (SBA) were available to nonprofit organizations. The SBA is all about strengthening the country’s economy, and as a business banker the SBA was at the top of my list of resources for entrepreneurs as they started and grew their businesses. When I made the change to work exclusively with nonprofit organizations I was disappointed to lose access to those programs. Nonprofits are businesses, after all, with a significant role in employing people and generating economic activity. Minnesota Council of Nonprofit’s Minnesota Nonprofit Economy Report for 2008 reports that nonprofit employees represent about 10% of the states’ workforce, paying $12 billion in wages.

What I’ve missed most were the Small Business Development Centers that offer workshops and one on one help and the SBA loan programs that provide crucial growth funding. In a way, Nonprofits Assistance Fund and other capacity building organizations have filled this role for nonprofits.

Potential Nonprofit Resources

I’m very glad to know that the beginnings of some new resources for growing strong nonprofits are contained within the Serve America Act, passed in the last week in both a Senate version and House version. The President is expected to sign it next week. The amendment that creates a new program for nonprofit capacity building is summarized here by Independent Sector.

Housed within the Corporation for National and Community Service, the bill authorizes $25 million over five years to provide organizational development assistance to small and mid-size nonprofit organizations, in particular to “strengthen small charities around our country, especially where resources are scarce.”

I’m hopeful that we can get these resources out in the community soon, focused on building strong community organizations that know how to balance mission and management. I’ll keep waiting for an SBA loan program for nonprofit businesses. In the meantime, if you are in Minnesota and need working capital or a line of credit, Nonprofits Assistance Fund’s loan fund is here.

The topic of social enterprise comes up often in discussions and meetings that I have with nonprofits, businesspeople interested in nonprofits, and foundations. I keep tripping over the lexicon, though, because I don’t think that the commonly used terms are certain, universal, or completely clear. It seems that the “field” encompasses a number of different types of organizations with different definitions and identifiers. Because I dance around these phrases so often, I looked around the other day to compile definitions for these terms in regular use.

Social enterprise is defined by Social Enterprise Alliance as “an organization or venture (within an organization) that advances a social mission through entrepreneurial, earned income strategies.” This often reflects a market-based effort to receive earned income in direct exchange for a product or service. Examples of social enterprise from SEA include:

• A substance abuse treatment facility operating a moving company
• An organization promoting college enrollment that provides workshops to educators
• A youth services organization opening a pretzel shop or ice cream shop franchise
• Goodwill thrift stores

Social entrepreneurs are defined by Ashoka as those who “act as the change agents for society, seizing opportunities others miss and improving systems, inventing new approaches, and creating solutions to change society for the better. While a business entrepreneur might create entirely new industries, a social entrepreneur comes up with new solutions to social problems and then implements them on a large scale.” Examples include:

• Jim McCorkell, founder of Admission Possible (an Ashoka Fellow)
• Muhammad Yunus, founder of Grameen Bank

A socially responsible business is defined as a venture (generally for-profit) that seeks to “leverage business for a more just and sustainable world” (Social Venture Network) or “help create a better world by building healthy communities, promoting economic equity, and fostering a clean environment” (Social Investment Forum). In addition to generating a profit for shareholders, these businesses have goals in the areas of economic development, employment, environmental practices, or ethical business practices.

For me, the key distinctions between these terms are the following:

• Social enterprises are defined by revenue source
• Social entrepreneurs are defined by innovative vision and strategy
• Socially responsible businesses are defined by the intention and goals of a for-profit business
  

It may seem to some people that the definitions are just semantics, but I think they’re important if we want to create resources, find capital, and develop a knowledge base. The needs and demands are probably different if your focus is on revenue sources rather than a game changing strategy.What do you think - do these definitions matter? Are the three listed here on the right track, or would you offer some others?