Completing our business school education during the time of COVID-19 has been an eye-opening experience. Our studies in systems thinking and leadership offer a unique lens to view the significant flaws in America’s institutions and shortcomings in national leadership exposed by this crisis. We are witnessing how decades of underinvestment in public sector institutions and historically low levels of trust in government have left the federal bureaucracy ill-prepared to deal with a shock of this magnitude. In the absence of clear national leadership from the government, many expected the dynamism of America’s private sector to fill the void. While select companies have risen to the challenge, in most communities nonprofit organizations have been the primary entities attempting to meet the skyrocketing demand for everything from essential services to health care equipment, even as their own financial futures are as uncertain as the futures of the communities they serve.
Nonprofits and social enterprises tackle many of the thorniest challenges faced by society — problems that demand complex, sustained action and long-term investment. Yet these organizations are too often financed for the short-term, primarily through individual contributions and restricted philanthropic or public funds. The marketplace for social sector financing therefore largely fails the institutions and individuals in most urgent need of sustainable support. We must leverage the present crisis to implement bold changes that build financial strength and equity in the nonprofit sector.
The misalignment between funding and objectives in the social sector has been the focus of our work over the past year as research assistants for Andrea Levere, an Executive Fellow at the Yale School of Management and President Emerita of Prosperity Now. Her project, Charting the Next Wave of Equitable Finance, was launched in the Fall of 2019 through the International Center for Finance at SOM, in partnership with the Program on Social Enterprise, Innovation, and Impact. The work built on Clara Miller’s 2018 call to revolutionize capital in the social sector: “If we want philanthropy to stay relevant in today’s 21st century world […] we must revolutionize our 19th century business model, operating precepts and conceptual frameworks to be fit for our purpose. […] Without access to some form of equity-like capital, nonprofits are pretty much sentenced to difficult, unhealthy, or slow growth.”
Each of us brought a unique perspective to this work, as our prior careers spanned the private, public, nonprofit, and philanthropic sectors. In our research, we examined the collective practices of these sectors with the goal of understanding how financial tools can be adapted to better serve people and places left out of mainstream markets. Our conclusion is simply this: we should fund nonprofits using the same fundamental principle that drives enterprise growth and sustainability in the for-profit sector – matching sources and uses of funds – to provide reliable, scalable financing to build strength and resilience in the social sector.
Creating a New Asset Class for Enterprise-Level Capital
Mainstream capital markets offer multiple ways for companies to secure equity, including early-stage venture, growth equity, and public offerings. Investors understand that this capital is necessary to support different stages of the enterprise’s life cycle. Start-ups must acquire and maintain assets – including human capital, operational infrastructure, and research and development capacity – and over time build the balance sheet necessary to attract additional financing. Nonprofits and social enterprises share these needs in addition to facing other unique challenges posed by their missions, yet they are often discouraged or prohibited by funders from earning profits and reinvesting them into the operations of the organization. Instead, these organizations are asked to rely largely on individual contributions and short-term, and generally restricted, philanthropic and public grants.
This arrangement pulls organizations in two directions as they must simultaneously (1) staff robust fundraising departments that can repeatedly identify and obtain funding and (2) minimize overhead costs in order to maximize programmatic output and meet donor assessments of organizational efficiency. In addition, the restricted nature of most grants often limits what the organizations can do with the funds that they receive: instead of trusting the nonprofit or social enterprise to determine what the best use of funds is, as is typical in private sector financing, donors often require that the money be used for specific projects. Caught in this Catch-22, nonprofits and social enterprises have limited ability to build the asset bases necessary for sustainable growth and financial resilience. The consequences are evident today, as nonprofits are being asked to scale up their programming without the financial reserves necessary to do so.
Given the limitations on the legal and tax status of nonprofit organizations, we considered the main challenges nonprofits face and how we might address these challenges by adopting lessons from mainstream capital markets. We assessed what steps could be taken to create a new “asset class” that enables philanthropists and impact investors to align financing mechanisms with the impact objectives of the social sector. Specifically, we explored ways to scale the delivery of “enterprise-level” (or “equity-like”) capital to nonprofits and social enterprises:
(1) Challenge: Nonprofits do not have access to long-term unrestricted funding, which undermines program expansion and contingency planning. The funding they receive is often restricted or tied to certain covenants that require “re-engineering” their balance sheets and operations to manage their cash flow.
Solution: Maximize liquidity through access to unrestricted (or less-restricted) funding. This can be done by expanding and prioritizing multi-year funding; crafting policies that incentivize higher levels of spending by foundations and donor-advised funds; and creating specific enterprise capital products tied to social sector financing, such as the inclusion of a 15% net asset grant with all program-related investments.
(2) Challenge: Nonprofits are often dependent on a few powerful donors and/or philanthropic institutions, whose objectives sometimes differ from the outcomes nonprofits and target communities truly need. This phenomenon can require nonprofits to adapt their business models to suit the bespoke needs of funders and creates market gaps in funding.
Solution: Diversify financial risk through collaborative grantmaking. Just as start-ups may seek to diversify their investor base to maintain autonomy over decision-making, nonprofits need diversification so that no single donor has outsized control over the organization. This can be done by increasing collaboration among funders and/or creating pooled funding initiatives in which funders share learning, data, evaluation metrics, and accountability. Models for this kind of collaboration have already been piloted and work best when focused on specific geographies and issue areas, as in the case of the Boston Youth Violence Prevention Funder Collaborative that operated from 2009-2016. Within these initiatives, funders can maintain the freedom and flexibility to grant independently while coming together on broader strategic goals and evaluation metrics. This alignment not only spreads risk among the funders, but also raises the profile of the target issue and attracts additional attention and funding for grantee organizations.
(3) Challenge: Nonprofits, like their for-profit counterparts, would benefit from collaboration to scale impact, yet these collaborative efforts are not widely incentivized, and donors themselves often act in isolation.
Solution: Facilitate partnerships between nonprofits and across the nonprofit, public, and private domains. Just as investors facilitate introductions on behalf of investees, donors should leverage their networks and connect like-minded organizations, thus increasing avenues to exchange ideas, share best practices, and pool resources. While such occurrences are rare, recent success stories have been documented in the Stanford Social Innovation Review, illustrating how alliances between improbable partners have led to improved impact outcomes. Another example is JP Morgan Chase’s PRO Neighborhoods Competition, which provides enterprise-level capital to CDFIs and other nonprofits that work in partnership to invest in financially underserved areas to promote cross-sectoral solutions.
(4) Challenge: The lens through which we assess nonprofit financial performance and impact is outdated and discourages nonprofits from seeking the type of capital they need to fully fund operations and scale. Funders also lack a standardized language to evaluate impact. The absence of shared language and evaluation metrics hinders efficient information exchange and penalizes the delivery of enterprise-level funding, which does not translate directly into specific “outputs” or “outcomes.”
Solution: Standardize the practice of “co-created” metrics for funders and grantees. Leaders in the social sector should coalesce around a commonly accepted framework of financial and impact metrics to save valuable time and resources for nonprofits. This can be done by standardizing enterprise-level investment parameters and metrics to track performance and return as well as rethinking how we interpret metrics such as the current ratio and operating margin.
(5) Challenge: Relationships and connections are crucial assets for nonprofits, yet many organizations, particularly those that serve marginalized communities and/or are run by people of color, do not have direct access to major sources of capital or the networks that can provide them. Studies have also demonstrated that implicit biases and limited knowledge about certain issues among donors also contribute to the disproportionately low funding these organizations currently receive.
Solution: Democratize access to capital. This can be done by creating and leveraging new technology platforms to match donors with organizations. Such platforms should take an elevated and broad perspective on issue areas, promote transparency in uses and impact of funds, and reduce barriers to entry for funders and nonprofits. Ideally, new platforms will reduce the nonprofit sector’s reliance on relationship-driven funding models to secure resources from philanthropic organizations and individual donors.
We are thrilled to see many of these recommendations brought up in philanthropic circles since the beginning of the COVID-19 crisis, such as the call for charity stimulus policy, which mandates higher foundation payoffs, and the philanthropic call to action signed by more than 750 foundations who have pledged to loosen restrictions and reporting requirements for current grantees, make new unrestricted grants, and support advocacy for important public policy changes. Our hope is that these conversations not only continue throughout the crisis but are also expanded upon for the long-term and advanced in daring and sector-defining ways – including via a commitment to enterprise-level capital.
The pandemic has highlighted the essential role that the nonprofit sector plays in American society, and any sustainable path forward must ensure that the capital markets these organizations depend on are built with their long-term financial strength in mind.