Managing Partner, Acorn Advisors LLC
This essay is adapted from my video segment in the free online Nonprofit Management Essentials course developed by the Kellogg School Center for Nonprofit Management at Northwestern University with the support of The Allstate Foundation.
If there is one idea you take away from this essay, this is it: the term “nonprofit” reflects tax code, not a way of doing business.
The Internal Revenue Service code number 501(c) describes many types of organizations that are exempt from paying taxes. What usually comes to mind when we think of the nonprofit sector are the educational, social-service, environmental, and cultural organizations and foundations we sometimes call “501(c)3’s.” The broader 501(c) code also includes a surprisingly wide variety of other types of organizations, including clubs and religious associations; in other words, nonprofits that exist to serve their members.
But just because a nonprofit doesn’t pay taxes, doesn’t mean it can lose money!
A nonprofit must have enough money to fulfill its purpose. Just like a for-profit company, a nonprofit organization needs to be cash-flow positive more often than not and must have sufficient funds in the bank. If it doesn’t, it won’t be able to grow and endure. If our health clinics, chambers of commerce, and after-school programs don’t make a profit then they can’t competitively pay staff, maintain facilities, grow their reach, or anything else. Over the long term, a nonprofit’s positive net assets, known generally as profits in the commercial world, are essential to fulfilling its mission. The bottom line is that nonprofits must make money to thrive and to survive.
So, how does a nonprofit make enough money to stay in business and to grow in pace with rising costs and expanding demand for services? While there are as many different business models as there are nonprofits, every financially successful organization has two factors in common: 1) A capable chief executive who is also a financial leader—not only a budget manager; and 2) A competent board of directors that supports the chief executive while providing additional focus on the budget and bank accounts, all the while staying in their own lane of governance responsibility. Together, the chief executive and board of directors need to create and sustain a business model appropriate for the nonprofit’s range of services that produces impact and financial wellbeing.
As a point of reference, according to the Urban Institute, National Center for Charitable Statistics, nonprofits on average receive 47% of their revenue from fees for service, 33% from government grants, contracts, and fees; 13% from charitable gifts; and 7% from other sources of income. We can consider a hypothetical museum to think about these numbers. For example, the museum might earn 47% of its revenue from memberships, ticket and program fees, store and café sales, travel programs, and service contracts. In addition to the money it earns, the nonprofit might raise 13% of its revenue from donors. These donors may be individuals—both during their lifetimes and through their estates, institutions such as foundations and corporations, event- and party-goers, and donations of gifts in kind. The third large bucket of revenue for our museum—in this case we’ll assume 33% percent—comes from proceeds from government tax levies like property taxes, and from government grants. The category “other” might include proceeds from an endowment, among other things. Having complementary funding streams helps the museum stay balanced and healthy.
There are many models that work well, yet there is debate about how diverse those sources should be. We’ve all applied the teachings of the phrase “don’t put all your eggs in one basket” to aspects of our personal life. We spread our retirement fund investments over different asset groups. We also usually apply to more than one college or job, try to eat a balanced diet, and in other ways hedge our bets every day. Therefore, it only makes intuitive sense to diversify the funding sources for any nonprofit—an approach I wholeheartedly support. For example, while I was leading the Chicago Botanic Garden during the financial crisis a decade ago, our annual fund donations took a dip, but our earned-revenue numbers climbed dramatically. More than ever before, people paid to visit our beautiful campus and take classes at our school. In this case, we were fortunate that an increase in one revenue stream helped to offset a temporary decline in another.
That said, there is another important perspective to consider. Nonprofit leaders must also exercise caution before spending too much energy to alter dramatically their sources of revenue. Let’s take an example from a Fortune 100 company to explain why a nonprofit should diversify with caution. Decades ago, General Electric offered a widely diverse set of products–from jet engines to lightbulbs to financial services and television programs. Today, GE has divested or is in the process of selling many of the product lines that made it famous. Other conglomerates also found out the hard way that a broadly diversified business model doesn’t ensure success. Granted, GE operates at a massive scale but the lessons for nonprofits are the same. Clara Miller notes in her article, “Shattering the Myth About Diversified Revenue” that “maintaining multiple, highly diverse revenue streams can be problematic when each requires, in essence, a separate business. Each calls for specific skills, market connections, capital investment, and management capacity.” In short, as the breadth and complexity of a nonprofit’s business model becomes more sophisticated, the risk of defocusing and “mission creep” rises. At the very least, the expertise of the organization’s chief executive, board, and staff must grow commensurate with the level of complexity.
The fact that there are two sides to the issue of diversification underscores how nonprofit leaders need to be every bit as experienced and financially sophisticated as their counterparts in the for-profit world. Just as there is no one way for a corporation to maximize shareholder value, there also is no one single way to run a tax-exempt “nonprofit” organization. However, for any institution to fulfill its mission over the long-term, the board of directors and chief executive must work together not only to stay true to the organization’s mission by listening to those it serves and evolving those services to meet changing needs, but also to bring in more money than the organization spends. Generating enough positive net assets (a.k.a. “surplus”) to build up both capital and endowment reserves, and investing those wisely and strategically in programs, facilities, financial instruments, and employees is essential for an organization to make the greatest possible positive social impact.