After Overhead: Investing in Nonprofit Financial Fitness

(Rebecca Thomas is a vice president at the Nonprofit Finance Fund, where she has strategic responsibility for national arts initiatives, funder partnerships, and product development efforts that advance NFF's profitability, visibility and impact.)

Recent efforts to end the overhead myth are to be applauded. But they don't go far enough. Funders also need to focus on nonprofit resiliency.

Increasingly, funders understand that "overhead" costs directly support an organization's ability to deliver results and that the overhead ratio shouldn't be used as a simplistic indicator of an organization’s ability to deliver on its mission. The bigger opportunity here, however, is to go beyond funding the full costs of delivering specific services to build an organization's financial strength through surpluses and savings.

After all, many nonprofit organizations that routinely fund their administrative and fundraising expenses often are operating perilously close to the financial brink. They lack the resources to develop innovative approaches to service delivery, take calculated operational risks, manage unexpected funding shortfalls, and cultivate new, more reliable streams of revenue. The loss of one big government contract, an unanticipated facility emergency, or a period of economic distress can be enough to push these agencies over the edge.

Nonprofit Finance Fund's 2013 State of the Sector survey showed that, three years after the official end of the recession, the majority of nonprofits are still unable to address the needs of people and communities they serve. While more than 70 percent funded overhead by bringing in enough revenue to cover their expenses, only 48 percent reported an ability to meet service demand, and 90 percent said the outlook for people they serve will be less certain or the same in the coming year.

Ending what the Bridgespan Group has termed the "nonprofit starvation cycle" is a worthy, but insufficient, goal. Having more money to pay for vital administrative staffing and systems may temporarily allay an organization's hand-to-mouth existence, but a more ingredient-rich diet is required to assure longer-term effectiveness. By adding a higher indirect cost allocation to project grants or service contracts, nonprofit investors are substituting immediate results for lasting financial and program fitness. By budgeting and managing only to break even, nonprofits are contributing to their own malnourishment.

If investing in and paying for critical overhead cannot assure a well-resourced organization, what will? What can funders measure and do differently so that their support fosters the financial agility nonprofits require to achieve better outcomes for society?

Funders can start by changing the question so often at the heart of their financial due diligence. Rather than asking, "Does my grantee correctly allocate overhead to each of its programs?" consider this alternative: "Does the organization's business model reliably cover its full costs and contribute to savings that can be used to advance its mission?"

Here are three metrics to look for when assessing the health of an organization's business model and capital structure:

Unrestricted operating surpluses. An organization that runs deficits is borrowing money or depleting its cash, jeopardizing the health of its programs and infrastructure. Breaking even every year is not enough for organizations with a long-term horizon. Annual unrestricted surpluses, after removing any one-time or extraordinary items (such as grants from a capital campaign, a bequest, or the sale of a facility), should be sufficient in size to meet annual debt obligations, pay for the wear and tear of fixed assets (i.e., fund depreciation), and contribute to some amount of savings. Deficits should be rare and, if they occur, part of an intentional plan for organizational change that includes a pathway to recurring surplus.

Months of working capital. For how long can the grantee operate with access to cash or near cash, net of short-term liabilities? Determining liquidity is often complex in the nonprofit sector because cash and investments can be restricted or earmarked for future purposes and therefore, unavailable for general and immediate use. Every organization has distinct liquidity needs so there is no hard-and-fast rule. Targets should be set in the context of an understanding of the cyclicality or seasonality of cash flow and be grounded in an analysis of program, market, and business risks. An organization with days or weeks of working capital may not be starving, but it certainly isn't surviving.

Board-designated reserves. In addition to short-term liquidity to manage the day-to-day, many organizations would benefit from longer-term savings that can be put toward adapting to changing market conditions -- a more realistic goal than reaching so-called sustainability. Reserves can be deployed for many purposes, including thoughtful innovation or risk-taking, enterprise-level change or growth, and facilities maintenance or investment. Look for evidence that a grantee's leadership has established specific policies governing the purpose, draw-down, and replenishment of its reserves. Reserves are typically held in unrestricted net assets, and may be described in the annual audit.

Achieving surpluses, savings, and reserves is no easy task. Nonprofits perpetuate the starvation cycle when they boast (as too many still do) that more than 90 percent of every gift goes to programs, instead of broadcasting how financial resiliency can lead to better outcomes for the people they serve. In truth, this "bad best practice" stems, in large part, from conditioned fear: fear of the consequences of admitting to supporters what it really takes to deliver excellent programs. This dynamic plays out in NFF's data showing that just one-quarter of nonprofits can talk to funders about working capital while one-third report comfort discussing reserves.

Overcoming this fear will take time. And notwithstanding funders' individual appetites and abilities to better capitalize organizations they support, nonprofits must take charge of their own financial health, even if it means making the tough decision to do less in the short term for the long-term advancement of the mission. Real change, however, must stem from funder action. Here are some practices that, when taken together, could go a long way toward improving organizational liquidity, resilience, and effectiveness:

1. Reward surpluses and savings (or at least don't penalize them!), while remembering that temporary deficits may occur during periods of planned organizational growth or change.
2. Engage nonprofits in conversation about the relationship between organizational strategy, program goals, and short and long-term capital needs.
3. Provide general operating support (GOS), which gives organizations the flexibility to deploy other, more restricted funds to direct program costs, increasing the likelihood of surplus generation.
4. Consider funding cash reserves for a specific purpose, such as to improve liquidity, support experimentation, care for fixed assets, or seed program or business model change.
5. If you can't make general operating or capital grants, fund projects at full cost by including a generous amount for overhead and a project surplus.
6. Support integrated strategic and financial business planning and more general financial education for executives and boards.
7. Be explicit about the type of support you provide, the time duration of your grant, and the outcomes you expect, so grantees can incorporate your contribution into their plans, rather than having to adapt their plans to the grant's terms.

While nonprofits bear responsibility for communicating their true, comprehensive financial resource needs, funders can lead by encouraging business models that reliably cover full costs and supporting capital structures that are sufficiently liquid. Our sector's ability to truly solve pressing social challenges hangs in the balance.

-- Rebecca Thomas