Balancing the Mission Checkbook

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?

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.