The Looming Recession

A recession is defined in classic economic terms as 2 successive quarters or more of negative GDP growth; by this definition, the economic situation of the 2001 - 2003 period would not be classified as a recession. Economists, however, have refined their view of recessionary economic trends - by these definitions, the Wall Street Journal was reporting that the economy was in recession last quarter, and continuing into this quarter.


Whether we are yet in a classic recession, which appears likely to occur in any case, it is clear the economic situation is a bit gloomy, with chances for "a hard rain that's going to fall" in the near future.


The nonprofits we talk to are concerned about the current economic state, and they should be. From preliminary research we have done, supporting research done by many other groups, the nonprofit sector's funding will be impacted by any recession. Of more concern, this recession may be even more troublesome for nonprofits than those of the past 20 years.


It appears clear that the the size of the philanthropic giving pool, as reported in Giving USA, varies between 1.7 and 2.3% of GDP. When GDP growth slows, or declines, not only does the growth in the pool of available philanthropic giving funds slow or shrink, but also, because of declining economic fortunes overall, the percentage of GDP allocated to giving also declines. So there are less funds in general available for giving, and the amount of funds individuals allocate to giving also declines.


If that were not of concern enough, Giving USA also has noted that since 1966 the percentage of GDP has maintained a minimum level of 2.0% of GDP for nearly 20 years. There may be many reasons to explain this plateau - the most obvious is that during the 1990s the U.S. enjoyed the longest period of sustained economic growth ever. This was followed by a period of sharp decline in the economy - interestingly enough, however, consumer sentiment remained high even during this period. This even though the recovery was tepid at best, and created very few new jobs in the economy - the so-called "Jobless Recovery."

Finally, individuals are seeing reason to be very conerned about the value of what are generally the single largest assets they own - the value of their homes. Some pundits have argued that consumer spending mitigated what could have been a much longer, more difficult economic downturn, and this buoyant economic spending was at its core driven by a strong housing market. We all know what is happening there . . .


So what does this mean for nonprofits?

I think nonprofits need to be prepared for the reduction in available philanthropic giving funds in the face of this economic downturn. I also think that, given the housing market, the tepid recovery from the last downturn, and the lack of jobs creation, this downturn could very well see the philanthropic giving pool drop off of the 2% of GDP plateau it has maintained for all of these years. So the philanthropic giving pool will be defined as a smaller percentage of a slowing or declining GDP figure. I also think it is important to note that the largest donors to nonprofits are probably most directly impacted by economic downturns in terms of value of available liquid assets, so going to your best few is going to be a difficult sell when they are worried about their own portfolio of assets.

I think many nonprofits will try to spend their way out of the current economic downturn if they can, allocating more resources to customer acquisitions and re-activations. Others will reduce staffing and / or mission delivery levels to wait out the economic storm. From our perspective, the former may have some effect, but at great cost - new acquisitions in good times are getting harder and harder to come by; in times of economic gloom, these methods will be even less effective, more expensive, and still deliver less Value of Direct Benefit. The latter is also a reasonable response, but the natural implication is that hard-won relationships to some degree will erode, and / or the public's confidence in the nonprofit will decline, leading to more skepticism and more hurdles to generating substantial support.

We have spent a lot of time looking at quite a few representative nonprofits, and we believe that there is a third way to weather the storm - we've found time and again that there is tremendous value locked up in the donors you already know. The problem is that there hasn't been an effective way to find and manage, out of tens or hundreds of thousands of donors, some manageable number that can backfill lost income. By effectively and efficiently broadening your visibility into your donor pyramid, picking a number of best prospects - be they "Hidden Gems" (donors underperforming compared to their peer group); at risk donors (donors who have lapsed or have reduced support for your organization); or Up and Coming donors, who are showing moderate levels of giving with high growth or consistency. By mining for these donors that previously were difficult if not impossible to efficiently mine, you can broaden your base, backfill lost support from your typical "bread and butter" development activities, and maintain or even grow during this time of economic decline.

It's all about finding and efficiently and effectively managing a larger number of relationships, broadening and deepening your pyramid to mitigate the risks we are facing today; by the same token, the same principles will help you accelerate your growth during good economic times.

Good luck weathering the storm.

Kevin

What's wrong with CharityNavigator?

You'll find we have a rather heavy antipathy toward CharityNavigator and (to a lesser extent) other nonprofit 3rd party watchdog groups. It isn't that we don't believe the motives of these organizations are pure; in fact, we are fairly certain they are quite pure.

The problem is, their ratings are nonsense, and undermine the purpose they are meant to serve. This is a classic case of the old axiom of "Garbage In, Garbage Out."

Let's back up a second. I don't claim this to be a detailed history of CharityNavigator, but I believe the substance is sound: CharityNavigator was funded by high net worth investors with the goal of helping potential donors understand how "good" a nonprofit is (and by implication, how worthy they are of a donor's investment). So CharityNavigator undertook to evaluate the IRS form 990, which is an informational tax return nonprofit 501(c)(3) organizations are required to file on an annual basis. From this, CharityNavigator invented a series of ratios and measures on which it would base its "scores" for nonprofits. This led to a great deal of excitement, and many nonprofit subsectors getting up in arms about various exemptions, which led CharityNavigator to begin adding caveats and dispensations to account for these criticisms. And interesting and very telling situations began to occur - we can talk about all sorts of issues, but the single most disturbing result is that frequently the largest nonprofits with the broadest scale and scope were being dinged in favor of small nonprofits with very limited scale and scope. Compounding this is the fact that the primary data source for the "voodoo" math of CharityNavigator's scores is the IRS 990.

So CharityNavigator purports to answer some critical question that appears to be having a material impact on nonprofits. This is a great time for one of my favorite questions: "What problem are we trying to solve?"

The basic problem they appear to be trying to solve is "which nonprofits are most worthy of a donor's investment?" Let's break that down a bit more - how do we define the relevant criteria for "worthiness" in this context? In the CharityNavigator case, it would appear that the ultimate criteria is that the highest possible percentage of funds raised goes directly to mission delivery in the current year, regardless of scale and scope of the benefit delivered. I don't think that's a very worthwhile goal (I'll get to that in a minute), but even if it were, all CharityNavigator is really doing is forcing nonprofits to become less and less transparent in their IRS 990 reporting, using every loophole possible to minimize any costs that are not used for Direct Benefit. This creates a vicious spiral, because through the CharityNavigator "psuedo-science," they are forcing nonprofits away from what any savvy investor (sorry, Donor) would want to know.

If you are looking to invest in a company, what do you want to know? What I would never want to see is that every dollar of revenue goes directly to investors - that works for about 2 days, and then the company is out of business. The fact of the matter is that I want revenue and gross margin to be very healthy; I want general and administrative expenses to be the right number, not the lowest possible number. I want to see a healthy net profit.

Implicit in this is my investment horizon (I'm not a day trader, after all) - let's say I plan on investing in a chain of fast food restaurants, and that investment will be a 5 to 10 year investment. I could look at a company that jacks up its prices, while clamping down on cost of sales, and all I have is an expensive, low quality product. I could keep G&A down by reducing my budgets for cleaning and upkeep, but all I get are dirty restaurants. I can keep capital expenditures, such as periodic remodeling and updating, to $0, but all I get are beat up and dated restaurants.

This situation would be a disaster to my investment - growth in revenue for beat up restaurants selling high priced, low quality food is not going to be very high; the value of this investment will be worthless in a few years.

If rated by CharityNavigator, out of 4 possible stars, this is a 4 Star investment . . .

So what's going on here?

CharityNavigator is propagating an unsustainable view of the nonprofit industry, wrapping it under the cloak of "science." The problem here is the assumption (I believe this represents a bias of the founders and funders of CharityNavigator) that the best nonprofits spend 100% of every dollar raised providing direct benefit - this is muddled thinking at best. Let's assume for a second that if we spent every dollar raised for cancer-related causes that we could find an innoculation for cancer by June 1, 2010. Does that help the people who are struggling with the effects of a cancer diagnosis made through May 31, 2010? What about the 50, 60 or 70 years people diagnosed with cancer prior to June 1, 2010 will have to live with the disease - what do we do about them?

These are complex problems - the mission of nonprofits are measured in decades and centuries, and yet CharityNavigator would treat them as though they were measured in discrete, 1 year periods. I think the Discovery Channel is creating a new series, sponsored by CharityNavigator, called "Flip That Nonprofit" . . .

That is not to say that the nonprofits are innocent bystanders in all of this; you will see that our position is that the nonprofit industry is currently facing a sea change - the proverbial "inflection point" - where the mass of the industry is moving beyond the traditional economics and mechanics of the industry. Things that worked in 1992 will not work today; compounding this is an erosion of confidence in the industry. What is creating this situation? Quite simply, nonprofits are relatively inefficient in raising funds, and therefore, it is also in their interests not to be transparent in their reporting - they take every advantage of the latitude afforded in the current IRS reporting regulations, to the detriment of public confidence in the industry.

So let's run CharityNavigator out of town on a rail . . . now what?

Going back to my investment example, I don't want to see the largest numbers or smallest numbers theoretically possible in any category - I want to see the right numbers. I want to see that the price is commensurate with the quality, which will deliver less in gross margin but much higher revenue figures because customers will come back for good food at the right price. I want to see adequate resources being spent on care and maintenance - people will come back to a clean, well kept restaurant. And assuming I am in the investment for the long term, I want to see that the company is investing appropriate amounts in keeping the restaurant chain current, efficient and in good working order. As a businessman, I am used to looking at and making judgments about balancing a series of conflicting factors to identify a healthy, sustainable investment.

I want to see the same things from the nonprofits I choose to invest in. Tell me how long you reasonably must exist to meet the requirements of your mission. Show me that you are raising funds as efficiently as possible - I assume raising a smaller number of large gifts is inherently much more efficient than raising the same amount through direct mail or risky special events that lead to very large numbers of relatively small gifts, as well as not insubstantial overhead costs. I want to see that you are investing in your own future and sustainability. And I want to see G&A costs that are as low as they can be - to maximize Value of Direct Benefit Delivered - without being so low as to impair the capacity-building and sustainability for the nonprofit to endure through to the end of its mission.

It is time for the nonprofit sector to regain the initiative in financial transparency, and get beyond the mumbo jumbo, psuedo-science of CharityNavigator.

And for those of us on the donor side, we have to allow the nonprofits to tell us what we need to know, understanding that the picture on first blush may not look as we expected. We also need to give nonprofits the time to effectively manage through this sea change in the industry to re-tool themselves for long term viability in the 21st century.

We know what to look for - lowered cost of funds raised through more efficient fundraising methods (a focus on developing relationships leading to increasingly large gifts), general and administrative expenses large enough to support current efforts as well as long term sustainability - which may include capital intensive capacity-building efforts. And ultimately, of course, we would like to see as much Value of Benefit Delivered as possible - but let's think about that not just in terms of who we help today, but how many people we can help for as long as they need that help.

KB

Is philanthropy a business?

Is philanthropy a business? It seems that every third time I open an article in a philanthropic journal or trade magazine, or look for books on the nonprofit sector, someone makes the point that the nonprofit world is very different than the for-profit world, and it would be a mistake to let that point go unrecognized and attempt to apply similar rationale to such disparate realms. We have also had opportunity to talk about the nonprofit sector with many investors and high net worth individuals over the past 18 months, and there are two points that become clear: 1) they believe the assertion above that the nonprofit sector is irretrievably different and alien to the for-profit world; and 2) the implications of that assertion are counterproductive to a healthy, vibrant nonprofit sector.

I think the essential question here bears further clarification: what does it mean specifically that nonprofits are different than for-profit entities, and what are the ramifications of those differences?

One might argue that the essential lack of a profit motive is one factor that makes the nonprofit sector different. In the for-profit world, the profit (or net income) line serves the purpose of delivering value to owners and investors. It may be a logical trick (feel free to comment as you see fit), but I tend to see Net Income analogous in the for-profit world to something Contingere calls "Value of Benefit Delivered." In the nonprofit world, donors are really investors - they are looking for a return on their gift; just not in dollar terms, but in terms of delivering benefit to a cause, mission or institution they care about. The Value of Benefit Delivered is therefore the amount of each donated (invested) dollar that fulfills the need (return) required from the donor.

It is important to note that an investor in a for-profit company doesn't expect to be paid out of the Revenue line or even the Gross Margin line - a savvy investor understands that it takes money to build strong companies worthy of investment. Simplifying a bit, the investor is therefore paid out of the Net Income line - what's left over after the sales are made and the costs of paying for a strong, sustainable company have been paid.

I think nonprofits (and the regulators and 3rd party watchdogs looking over their shoulders) should rethink a critical point: are client programs, research, advocacy costs, capital costs of opening a new school at a university, etc. General and Administrative expenses? I for one don't think so, because, and I think this is the critical shift in thinking - those items listed are the return the investor seeks. Therefore, rather than counting those direct mission delivery costs as General and Administrative expense in a traditional income statement, these direct mission delivery benefits are paid for by the net income generated by the nonprofit.

If you think about the investor's (or donor's) motivation, it is to spend their money to realize some return - the difference between the for-profit and the nonprofit sectors is that the for-profit return is measured in dollars, while the nonprofit return is measured in a sense of doing good through the Value of Benefit Delivered (plus a nice tax write-off).

This leads to a second difference, and this is truly a difference that works to the detriment of the nonprofit industry: the lack of transparency in financial reporting from nonprofits - there are reasons only 25% of the U.S. public believes the organizations in the nonprofit sector do a "very good" job of supporting their respective missions, and one of the most onerous is this lack of reporting transparency.

In publicly traded companies - and I think we should consider, given the amount of money flowing to the nonprofit sector and their preferential designation in the tax codes, that they should be measured by a standard of transparency more like publicly- rather than privately-held companies - detailed, audited financials following very strict guidelines should be in place to ensure appropriate levels of transparency. The nonprofit sector can either voluntarily adopt these guidelines or have them mandated by various regulatory agencies; if given a choice I would always pick to choose my future rather than have someone else do it for me.

Many on the for-profit side are nodding their heads vigorously (one wealthy individual said to me that the reason he only donates to capital campaigns is because he knows exactly where his money is going). Others may be saying "What? There is an issue with the way nonprofits report their financial results?" For those in the latter group, try an experiment: ask an executive in the nonnprofit sector how much of each dollar you donate goes directly to mission delivery - the chances are very high they will say something like "our cost of funds raised is [a number between 10 and 25%], leaving you to infer that 75 - 90% is the answer to your question. If they don't say that, they will say something like 80 cents of every dollar. Immediately ask them if that includes General and Administrative costs; I would be surprised if they don't say "No, our G&A is 6 to 8 percent," or something like that.

So what's going on here? Are the nonprofits misleading us? While one could argue that 75% of the American public think so, I would argue that, no, nonprofits are just following IRS guidelines regarding how their financials may be reported to retain their nonprofit designation. More importantly, they are using this "loophole" as a basis for reacting to a groundswell of criticism from 3rd party watchdogs about those "financials." The nonprofit sector has lost the initiative with respect to transparency, and therefore are on the defensive about ratings posted by organizations such as CharityNavigator.com (we'll have LOTS MORE to say about them in an imminent post).

The problem here is that as businesspeople we think this is a very straightforward question: take the revenues you generate each year, subtract the Cost of Funds Raised (Cost of Sales), subtract General and Administrative expenses, leave an amount for reserve (Retained Earnings), and what is left over should be the value of the benefit delivered. Simple, right?

Not really, for two reasons. The first reason is that the IRS allows for something called Functional Allocation - so someone whose entire job is to raise funds can allocate part of their salary to Education and Awareness (a Direct Benefit Delivered), because they can count x% of their time spent talking about the organization as Education and Awareness; if a brochure for a fundraising event talks about the organization, then only part of the cost of that brochure counts as fundraising costs. So nonprofit fundraising costs, if you remove this "functional allocation" allowed by the IRS, are substantially higher than what is currently being reported.

To give the for-profit analogous situations, I have sales people who talk about our company all the time - I do not divide their time between selling and "Education and Awareness;" similarly, the full cost of a brochure goes into my marketing line under operating expense. Period. But over 3,000 nonprofits that generated $250K or more in philanthropic giving in a recent study reported absolutely no fundraising costs. Manna from heaven . . .

The second reason for explaining this lack of transparency is that, if a nonprofit must count Value of Direct Benefit Delivered costs in G&A, then the costs of funding the mission as an ongoing concern are intermingled with the costs of delivering direct support for the mission.

We'll talk more about this issue of transparency; in my opinion nonprofits should report their financial results (in addition to the manner mandated by regulators) in the form of

Revenue
- True all-in fundraising costs (no functional allocations)
---------------------------------
Gross Income
- General and Administrative Expense (excluding true mission delivery costs)
- Strategic Initiative costs (analogous to "Capital Expense")
- Management Reserve
---------------------------------
Funds available for direct mission delivery (Net Income in the for-profit world)
- Total Value of Direct Benefit Delivered
---------------------------------
$0

A final difference for now (we will discuss more, but these are the cornerstone issues) is the perception that the for-profit world is full of savvy businesspeople motivated by money, but the nonprofit world is full of people, typically with lower levels of experience, that are very mission-driven, without a profit motive. Steve Wozniak, the inventor of the Apple and Apple II computers, had no desire to make money or build a big business - he just wanted to build cool things; that sounds pretty mission driven to me. I can tell you from experience that I have worked for and with very savvy business executives; I have also worked for and with business executives who couldn't read a financial statement to save their company (literally).

I've also seen senior nonprofit executives who have little visibility beyond their narrow silos of concern, be it special event fundraising, direct mail fundraising, etc. to understand how their efforts integrate and support the larger efforts of their nonprofit as a whole. On the other hand, I have worked with very strong, savvy nonprofit executives who understand their business, the rapidly changing business environment in which they must operate, and are searching, just as GE and P&G are searching, for growth in an increasingly competitive and difficult market.
So in the end, philanthropy is a business - an interesting and very unique business, but a business nonetheless. And it is a business funded by people from the for-profit world - and the more successful the for-profit businessperson, the more support s/he provides to the nonprofit.

We think, therefore, that it is time to quit explaining why nonprofits are different than for-profits, and rather spend time bridging the gap between the two. Because the nonprofit sector is serving a critical role in the economic landscape that no other entity, be it government or private industry, is willing to fulfill, and it needs the dollars earned by savvy investors in the for-profit world to provide the financial resources for support. These two constituencies must come together with a common understanding of the economics, issues and mechanics of the nonprofit industry if they are to effectively partner to fufill the needs required of the sector. I also think that to create arbitrary distinctions between what nonprofits do and what business does defeats the goal of a common understanding so necessary to secure and ensure the financial support the sector requires.

For the greater good . . .