Balancing the Mission Checkbook

This week has brought an interesting alignment in the discussion, or debate, about the future of philanthropy. Last Sunday, the magazine section of The New York Times was all about “Giving it Away” and trends in philanthropy. One particular article, “For Good, Measure” discusses a current hot topic: “Foundations are increasingly using “metrics” to determine if their grants are working. But can you really measure the return-on-investment of giving to a cause?” The article is one of many that I’ve read on this theme of trying to quantify impact, and it’s direct cost and value. An interesting article and we could debate many of the points. I really paid attention, though when, in a single day this week, two business leaders in Minneapolis asked me if I had read the article. They were impressed and very interested. That was a sign to me that this is moving from the conferences and into daily reality.

On the heels of this article, Nonprofit Quarterly offered a preview of a new book, Just Another Emperor: the Myths and Realities of Philanthrocapitalism, by author Mike Edwards, opening with:

“A new movement is afoot that promises to save the world by revolutionizing philanthropy, making non-profit organizations operate like business, and creating new markets for goods and services that benefit society. Nick-named ‘philanthrocapitalism’ for short, its supporters believe that business principles can be successfully combined with the search for social transformation.”

Edwards makes a strong argument that this movement is the wrong direction for several reasons, chiefly that social transformation is an entirely different “product” than producing goods and services. The preview sparked a lively response in blogs and on NPQ’s Forum from leaders in the sector. There is an air of “think tank” to this for me, though. We can have a healthy, and undoubtedly lengthy, debate on theory, myth, and reality. Most of the nonprofit organizations that we work with every day are not immediately affected by this trend, if that’s what it is. Most charitable dollars are still received from individuals or from traditional grantmaking practices. For “service-providing” nonprofits, delivering the essential social services, health care, and education needed in the community, public dollars dominate and are unlikely to take a radical turn towards long-term “investment.”

The growing awareness of philanthrocapitalism in the business world will require an equal awareness and response from nonprofits. If you think this debate can be ignored and relegated to the think tankers, I’d suggest that the discussion is important for us all to pay close attention to. Remember that there was a time decades ago that the basic structure of grantmaking was created. You wouldn’t want to be caught napping if the world that you know really changes. This topic relates to my post last week, which generated a comment recommending the book Good to Great and the Social Sectors by Jim Collins. Edwards also notes this short (35 pages) and valuable book - add it to your must read list.

We’ve worked with several nonprofit organizations during the difficult period leading up to closing the organization. Sometimes the decision is internally driven and intentional, and sometimes it’s after fighting it, kicking and screaming. How do you know if it’s time to close, and how to make such a monumental decision? I can think of three specific instances with very different characteristics and outcomes. The first is an arts organization that carefully and systematically paid their obligations and closed their doors after several difficult years of declining earned and contributed income; the second a youth-serving nonprofit that stayed in denial for too long before filing bankruptcy and leaving both students and creditors uninformed; and last is a small organization that remains in operation, though their relevance in the community and support from both donors and volunteers dropped off years ago. They stay alive as long as the director is willing to work with little compensation and little support. In another situation, though, I worked with an organization whose executive director repeatedly suggested closing the doors because fundraising was so difficult. The board realized that the mission was as vital as ever, though, and the solution was a different, less burned-out, director to bring new energy and ideas. These are important organizational questions that touch on financial, governance, fundraising, and mission questions. There aren’t easy answers or absolutes when it comes to closing or changing structures. Come participate in an ongoing discussion of these questions in an online discussion at Nonprofit Quarterly’s Web site - see the invitation from editor Andrew Crosby below.

Find out how one organization weighed the decision about whether it should close, and contribute your own analysis of whether they made the right decision in the Nonprofit Quarterly Online Forum.

Beginning today you can join Mark A. Hager of the University of Texas, San Anton, and Kate Barr of the Nonprofits Assistance Fund in the Twin Cities, to discuss “The Ultimate Question,” authored by Mark and published in the Fall 2007 issue.This will be a great discussion for executives, consultants, board members, and funders interested in how such decisions are made — and may be considering such decisions themselves.Just register on NPQ’s Web site to access the Forum and join us for a thought-provoking exchange where you can offer your experience, pose questions, and comment on those of others.

Once you have registered, a link to the NPQ Forum appears under the User Menu. Inside you’ll find a reprint of the case, financial background material, and some starter discussion threads that you can add to, comment on, or create your own.

So register on the NPQ Web site today to participate.

Andrew Crosby, Editor

p.s. If you have any technical questions, contact webmaster James Morgan. For any questions regarding content, please contact Andrew.

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’ve had several discussions lately with board members of nonprofits on financial management topics that had an odd, disconnected feel to them that I couldn’t pinpoint at the time. One was about operating reserves and how much was the ideal amount to have in reserve – 3 months, 6 months, or a full year’s expenses? Another was about how to determine the best mix of income sources for a nonprofit that has grants, government contracts, and fee income. In both conversations I asked the board members my favorite question: Why? This is a set up, of course, since I think that reasonable reserves are valuable to have, and that understanding the sources of income is a key to financial health. The “Why” question has to be asked when financial matters are considered without any connection to the nonprofits’ mission - that’s the disconnect. The purpose of these particular queries had more to do with creating a financial model and satisfying the board members’ perception of their role than with improving the nonprofit’s ability to serve its community. Finding the balance is very hard, though, and we have few guides.

Nonprofit Quarterly has been one of those guides recently with their spring issue titled “Revenue is Destiny”. I enjoyed reading a preview of the summer 2007 issue, especially this excerpt from an interview with Richard Brewster, executive director of the National Center on Nonprofit Enterprise. NCNE “helps nonprofits make wise economic decisions”.

NPQ: What should boards focus on if they are concerned about long-term sustainability?

RB: This may be counterintuitive, but the central question is the quality of the program. In other words, the worst threat to nonprofit sustainability is if your program is crap. A nonprofit’s only reason for keeping going is to change people’s lives, communities, the environment, and so on for the better. If a nonprofit is not making the biggest difference it can with the resources available, it is being wasteful. From an economist’s perspective, it is not putting its resources to best use and is inefficient. I’d find it odd to apply the word sustainable in any really meaningful way to such an organization.

I love the directness of this comment. Why should nonprofit directors and board members be concerned about their financial and economic condition? As a tool to deliver good programs to change communities and lives, both today and in the future.

But what if your nonprofit doesn’t have audited financial reports? Does this item listed in the grant proposal form mean that you should rush out and hire an audit firm – or that without an audit you’ll never get a grant? Probably not – but you should understand what an audit is, why the foundation includes this on the checklist, and what alternatives you have. I’ve been asked this question many times by both nonprofit directors and foundation program officers. The short answer is this – no, you don’t have to have an audit for the majority of grant applications. Most foundations do not want to require a small nonprofit to spend $5,000 or more for an audit just to apply for a grant. In some cases, the cost of the audit would actually exceed the amount of the grant! Requirements for nonprofit audits depend on how funds are raised and various state and federal grant requirements, but the threshold for most nonprofits defined by the Attorney General in Minnesota is $350,000 in income. What the foundation really wants – and needs – is financial information that they can rely on. An audit is the ideal, but there are alternatives.

It’s helpful to first understand what a financial audit is – and what it isn’t. An audit report is a financial report prepared according to accounting standards and an accompanying opinion of a CPA that they have reviewed and tested the information and determined that it is accurate. This is called a “clean” opinion. The reason that funders like to see audits is because of this opinion about the accuracy of financial reports. It’s important to understand that the audit is completed using the financial reports prepared by the organization, not by the auditor. (In fact, the auditor cannot prepare the financial reports and then turn around and issue an opinion letter about them.) An audit is not an assessment by a CPA that the nonprofit is in a good financial position. Making that assessment is up to the organization’s staff and board and any outside users of the financial reports.

So without an audit, how can you provide accurate and reliable financial information that is acceptable to a current or potential funder? Go back to the description of what an audit is: a financial report prepared according to accounting standards. Without an audit you won’t have an opinion letter, but you can provide an accurate year end financial report including an income statement and a balance sheet. In order to do this, the financial manager or treasurer will have to prepare a “final” financial report for the year and have it available in a standard accounting format. It’s great if you create a PDF version that can serve as the definitive version. Along with this report, send your IRS 990 form to demonstrate that you have complied with the requirements for reporting and accountability. The 990 should be accurate, the information reported should agree with the financial report, and it should be timely. The executive director and development staff person or volunteer should be able to read and discuss both of these reports at a site visit or phone call.

I recommend an article in the current issue of Nonprofit Quarterly, “Absent the Audit: How Small Nonprofits Can Demonstrate Accountability Without One”, by Jeanne Bell and Steve Zimmerman. The authors suggest that there are three key functions of an audit for a small nonprofit: generating donor and constituent confidence, ensure compliance with accounting standards, and prevent or catch fraud. They propose a number of ways that small nonprofits can fulfill these same functions with a printed annual report, open communication of a summary version of year end results and the annual budget, and a timely, correctly prepared IRS 990. The article also includes some good advice about using a board treasurer or volunteer to help assure accurate reports and the importance of internal controls for any sized nonprofit.

At the beginning of the annual budget season, which for many nonprofits is in the fall, listen carefully and you will hear the wails of anxiety about what grants, contributions and contracts to include in the budget for next year. A frequently heard wail is: “Why can’t we be one of those nonprofits with grants that they can count on every year, and deep-pocket individual donors who always write big checks, and … if only we could be one of them, we’d be financially stable.”

I’ve heard this over and over. The truth is that this is a myth – and too many nonprofit directors and board members believe it. It’s an unusual nonprofit that has completely reliable and recurring sources of income year after year. Income, both contributed and earned, has to be continually researched, requested, proved, and unearthed by small, mid-sized, and large organizations. What makes a nonprofit financially stable is having the kinds of systems, plans, and people in place to do all of this consistently enough to get results they can count on. This means that we have to change our definition of the mythical financial stability.

The myth is that a nonprofit can find foundations and donors once and turn them into a never-ending stream. The truth is that nonprofits have to create a solid infrastructure for prospecting, requesting, completing, and maintaining grant and donor relationships. This is one of those bad news/good news realities. The bad news is that there isn’t an easy one-time fix for income budgets. The good news is that every nonprofit has the ability to create and build systems to bring in income consistently – if only they keep working at it.

For consistently interesting ideas and research about the financial reality of leading a nonprofit, read the Nonprofit Quarterly. Their most recent e-newsletter included a preview of an article profiling six income models for financial stability - Financial Independence: Six Approaches.