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For organizational resilience and impact, focus on business model not overhead

October 21, 2020

Conflict dynamics brainstormIt has always been a source of angst for ambitious not-for-profit organizations: how to ensure they can sustain and scale up impact while also building resilience to weather financial or other shocks. Often the focus is on increasing core or unrestricted funding and covering general operating costs through grant overhead.

The COVID-19 pandemic and national responses to it have exacerbated this challenge and, in doing so, have brought into stark relief important structural problems within the not-for-profit sector. What have been perennial issues for many not-for-profits — sustaining impact, financial resilience — are now existential ones.

In recent years, even prior to the pandemic, governments, private foundations, and other donors have openly recognized the need to cover a greater portion of not-for-profit organizations' general operating costs through grant funding. That in itself is a good thing. But I do not believe this approach, on its own, will lead to the long-term resilience of ambitious not-for-profits, nor will it enable them to effectively scale impact.

What will ensure more resilience and the ability to scale up not-for-profit organizations is the pursuit of new and creative business models that fit with their missions and activities.

In this article, I draw on my and colleagues' experiences of growing Conflict Dynamics International, a sixteen-year young not-for-profit working to prevent and resolve violent conflict and alleviate human suffering arising from conflicts.

Common not-for-profit business model

A common business model for not-for-profit organizations is that the organization secures contributions from donors to fund its charitable work. This support can be for the core operations of the organization or it can be for particular programs or projects. In either case, it can be restricted or it can be unrestricted in terms of intended use. Let's call this the Contribution-Based Business Model.

With this business model, not-for-profit organizations must fund their non-program expenses through a combination of: (i) contributions for general operating support; (ii) restricted core funding; and/or (iii) institutional overhead applied to program direct costs. [1]

In Conflict Dynamics' experience, the institutional overhead on grants from non-United States governmental sources has been in the range of 7 percent to 13 percent (see below). Many private foundations allow for institutional overhead in this range also, while a few support overhead costs at a higher level (e.g., MacArthur Foundation, up to 29 percent). In our area of practice, for organizations receiving funding from U.S. government agencies, the Negotiated Indirect Cost Rate Agreement (NICRA) can cover overhead, as I understand it, up to 22 percent.

From the not-for-profit's perspective, the core value exchange through the Contribution-Based Business Model goes something like this: "We (not-for-profit) will deliver social impact; you (donor) will provide funding and other resources to support the activities towards that impact."

Challenges with this business model

In our sixteen years of working in some of the most challenging conflict situations in the world, we have learned that the Contribution-Based Business Model is not sufficient to scale the impact of our organization and ensure its resilience. Perhaps it is better suited to not-for-profit organizations working in less-volatile situations, or those that deliver predictable program services, or have reached a higher level of annual revenue.

The types of shocks we have to insulate ourselves from are generally funding shocks. Of course, the COVID-19 pandemic is a unique, seismic shock. We have been able to adapt our program activities, and at the same time we have seen the funding shock from the pandemic. Conflict Dynamics is fortunate to have many wonderful supporting partners; however, even in normal times we have on occasion experienced U-turns on donor pledges, long delays in the disbursement of funds, and non-renewal of grants when the political situation changes unexpectedly (either at source or country of implementation!).

Back to the Contribution-Based Business Model, I see a number of challenges:

  1. In recent years, many governmental donors in particular have been reducing the percentage and scope of coverage of allowable institutional overhead on grants. For the types of grants we secure for our work, the following donors allow these overhead percentages: Sweden Ministry for Foreign Affairs (13 percent); Switzerland Federal Department of Foreign Affairs (10 percent to 13 percent); United Kingdom Foreign, Commonwealth and Development Office (10 percent); European Union (8 percent); Netherlands Ministry for Foreign Affairs (7 percent); etc.
  2. Many institutional donors have pulled back on the amount of general operating support and other core funding they are providing to not-for-profit organizations, preferring instead to fund projects. A colleague recently referred to this as the "projectization" of funding. This has direct tangible impacts on the ability of the organization to grow its infrastructure, as well as impacts in terms of staff retention, professional development opportunities, staff morale, and so on.
  3. When organizations are funding their core operations through heavy reliance on program-related overhead, the organization becomes vulnerable if its programs do not continue or face funding gaps. If experienced program staff and institutional memory are lost, this places additional demands on the organization.
  4. Whether for core- or program-specific funding, this business model requires the organization to proactively pursue new grants on a near continuous basis to ensure its sustainability. The transaction costs for securing a large number of smaller individual contributions are very high, and so that generally requires that the organization first reach a certain level of revenue and capacity.
  5. The fixed overhead on program grants induces dependency on this type of funding, because organizations get stuck in a Catch-22 of having to invest significant time in program fundraising, especially when scaling, which takes away from efforts to secure the resources to sustain the core of the organization.
  6. This business model makes it difficult to break through the small- to middle-size stage of growth. This is the "too small to be big, and too big to be small" range of $2 million to $8 million in annual revenue. At $3 million to $4 million average annual revenue, Conflict Dynamics is in this range. The reason for this difficulty is that economies of scale only kick in when the organization exceeds approximately $8 million to $10 million annual revenue. At $8 million in annual program revenue and 10 percent average overhead rate, the overhead amount would be $727,272 a year.
  7. Scaling impact may require upfront investments in new programs or new geographic areas. When there is high reliance on grant-related overhead, there are generally not a lot of funds available to invest in exploring new opportunities.

Ultimately this business model on its own results in constrained and unreliable funding for not-for-profit organizations. That reality, and the consequences for intended impact have been well recognized. Several institutional donors have made commitments to provide more general operating support or restricted core funding, both prior to and during the pandemic:

Much of these commitments and intended actions focus on what donors can do to help non-profits, and they also generally focus on the same business model. Some of the proposed arrangements for donors to help grantees cover overhead costs include outcome-based funding and all-in-one project pricing.[5]

Moreover, some donors are pursuing an approach based on equity philanthropy, whereby loans and investments are made to fund not-for-profit programs. This seems best suited to organizations offering program services that generate predictable revenue streams.

Conflict Dynamics' experience of donor funding flexibility during the pandemic has been mixed: in general, there has been a marked slowdown of decision-making on new funding; one private foundation partner has provided significant grant flexibility in light of the impact of COVID-19; and most governmental donors have not afforded much flexibility with their existing grants.

A constellation of business models

If the Contribution-Based Business Model is not the way to go, then what is?

I believe that for ambitious not-for-profit organizations to build their resilience and scale impact, they need to operate with a variety of business models. This means going further than the obvious strategy of diversifying sources of funding, to diversifying the actual business model itself.

Conflict Dynamics has been exploring an approach based on a "constellation" of five inter-related business models, all oriented toward realizing greater social impact.

Business model 1: Contribution-based. I am not suggesting "throwing out the baby with the bath water"; a contribution-based business model will continue to be an important model for not-for-profit organizations. But organizations need to push for more realistic overhead percentages on program funding, longer grant periods, more funding for core expenses, and so on. In its last three fiscal years, our grant revenue for programs averaged approximately 98 percent of our total revenue....so we have more work to do here.

Business model 2: Monetization. The second component of the constellation of business models focuses on monetizing something that the organization already does. This is about extracting added value from the organization's expertise, analysis, networks, and so on. For example, Conflict Dynamics has gained a lot of experience in the monitoring and evaluation of peacebuilding programs and is in a position to offer monitoring and evaluation services, for a fee, to other organizations.

Business model 3: Unrelated business income. In certain circumstances, tax exempt not-for-profit organizations can generate revenue from unrelated business income. In the United States, the Internal Revenue Service has stringent criteria for what constitutes unrelated business income, which can be subject to tax.[6]  There are exemptions. One area of interest is rental income. During FY2018–19, Conflict Dynamics had total office lease expenses of $109,429, of which $26,782 was covered out of institutional overhead. With an approximate average overhead rate of 10 percent on program grants, we had to bring in roughly $294,600 in program grants just to cover this single expense. Ownership of a larger office property can reduce or eliminate rental costs and generate income through the subleasing of office space.

I realize the pandemic is not an ideal time to get into commercial real estate; looking to the future, however, there will be opportunities in certain areas and locations to provide other not-for-profits with co-working spaces.

Business model 4: Investments. The fourth business model focuses on investment income. Organizations can approach donors to make an initial short-term investment for the purposes of kick starting an endowment. With a one-year investment of $100 million and a fairly conservative return, the organization could realize revenue of, say, $7 million over twelve months. That would provide the initial funding for an endowment for the organization, which would in turn could provide roughly $490,000 of unrestricted revenue a year. For an organization with an annual  budget of $5 million, that represents nearly 10 percent of its total revenue.

This level of investment is not implausible; recently, the MacArthur Foundation adopted an approach in one of its program areas, the 100&Change initiative, where it makes a very large investment in a single organization over three years. Through the initiative, in year one, it made an award to Sesame Workshop and International Rescue Committee in the amount of $100 million.

Business model 5: For-profit feeder. Not-for-profit organizations can set up separate for-profit ventures with the aim of funneling the profit from the venture into the not-for-profit entity. Many large corporations have charitable foundations, and the approach here is to do the same in reverse. This assumes that the not-for-profit can design and execute a profitable business model.

This business model also affords the opportunity to seek equity investments. In addition, certain types of entities, including public benefit corporations (B Corp) in the U.S., are eligible to receive program-related investments (i.e., low-cost loans) from private foundations.

All these components should be viewed as building blocks that can be combined in different configurations, depending on the needs and capacities of the organization; they are not mutually exclusive. In other sectors, governments and foundations facilitate reduced-risk "sandboxes" to experiment with business/regulatory models. Perhaps it's time for the social sector to test these and other components in a sandbox environment designed for its own unique needs.

Where does this leave us?

When I visited the Palais des Nations — the seat of the United Nations Office in Geneva — in late 2019, I was surprised to see the direct effects of the cash-flow crisis that the UN has been battling. To cite just one small example, some elevator banks were intentionally closed to save money, and some meeting rooms were out of use. The lesson is that when it comes to business model vulnerability, size really doesn't matter.

Covering more core costs through more unrestricted funding may be necessary, but it won't be sufficient to guarantee greater resilience and enable not-for-profit organizations to scale their impact. That requires the adoption of diverse and overlapping business models. The COVID-19 pandemic surely provides added impetus for moving quickly in such a direction.

Headshot_Gerard McHughGerard McHugh is founder and president of Conflict Dynamics International. A serial entrepreneur with more than thirty years' experience in international conflict resolution, humanitarian affairs. and health care, he recently founded a new venture, AidX, to help ordinary people achieve the extraordinary. This post originally appeared on Conflict Dynamics' Medium channel and is reprinted here with permission.

Notes:

1. In this article, the term "general operating support" relates to unrestricted funding for the operations of the organization. The term "core funding" refers to funding for the core activities of the organization and can be restricted or unrestricted.

2. For more information on the Grand Bargain, see https://interagencystandingcommittee.org/about-the-grand-bargain [Accessed October 12, 2020]

3. Maria Di Mento, "Five CEOs of Wealthy Foundations Pledge to Do More to Help Charities Pay Overhead," The Chronicle of Philantrophy, September, 4 2019. Available at: https://www.philanthropy.com/article/5-CEOs-of-Big-Foundations/247063 [Accessed October 12, 2020]

4. James B. Stewart and Nicholas Kulish. "Leading Foundations Pledge to Give More, Hoping to Upend Philanthropy." The New York Times, June 10, 2020. https://www.nytimes.com/2020/06/10/business/ford-foundation-bonds-coronavirus.html [Accessed October 12, 2020]

5. These are some of the approaches identified in the work of the Bridgespan Group’s "Pay What It Takes" initiative. See: https://www.bridgespan.org/insights/library/pay-what-it-takes/pay-what-it-takes-philanthropy [Accessed October 12, 2020]. See also: Jeri Eckhart-Queenan, Michael Etzel, & Sridhar Prasad, "Pay-What-It-Takes Philanthropy," Stanford Social Innovation Review Vol. 14 №3 (Summer 2016).

6. United States Dept. of the Treasury Internal Revenue Service (IRS), Tax on Unrelated Income of Tax Exempt Organizations, IRS Publication 598 (February 2019). Available at: https://www.irs.gov/pub/irs-pdf/p598.pdf [Accessed October 12, 2020]

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