Steps to Approach Nonprofit Capitalization Planning

“Simple can be harder than complex: you have to work hard to get your thinking clean to make it simple. But it’s worth it in the end because once you get there, you can move mountains.” Apple founder Steve Jobs said this in 1998, and it’s as true for nonprofit managers facing the question of how to ensure their organization is properly capitalized, as it was for the Apple team.

In the video below, the second in this series, Rodney Christopher lays out a clean and simple approach to developing a capitalization plan, which helps nonprofit leaders to assess and provide for their capital needs. A capitalization plan can also provide potential funders with a comprehensive, transparent picture of an organization’s long-term capital needs. In the first post in this series, Rodney underlined that capitalization alone is not the point: proper capitalization, including a clear understanding of capital versus revenue, greatly improves an organization’s chances of delivering successfully over the long-term on the missions we all care about.

Part 1: Investigating your organization’s needs

These opening questions can be a helpful way to establish some baseline information on which to build a capitalization plan.

1. What’s the size of your revenue, and how is it changing over time? The nonprofit business model includes both earned and contributed revenue. Don’t consider contributed revenue a bad thing! For most nonprofits it is elusive to become “self-sufficient,” with 100% of revenue from fees and no grants. For the purposes of being a healthy organization that is well-equipped to pursue its mission, it’s less important that revenue be earned, and more important that revenue be reliable or at least predictable. A follow-on question then becomes: How might capital help improve reliability or stability?

2. Do you own property? Many organizations have sizable buildings and land, but don’t have the money to maintain them long term. Capitalization planning includes assessing those maintenance needs, and creating a plan to ensure that there is funding for those needs at the right times.

3. Do you have an endowment? The amount  of actual revenue generated by even a sizable endowment can end up being very small compared to the annual expenses of the organization, and entails having a large amount of cash set aside that the organization can’t touch. Rodney shares a favorite saying of his by Clara Miller, Heron’s president emerita (and founder and longtime CEO of Nonprofit Finance Fund), “You should only raise money for an endowment if all of your other fundraising needs are being met reliably every year forever.” Few organizations have that kind of reliability in their revenue. As such, we urge most nonprofits considering endowments to reconsider more practical uses of capital.

4. Do you have reserves? Most organizations do not have reserves that appear transparently on their balance sheets with written policies explaining what those reserves are for, under what circumstances the organization will use them, and how they will be replenished.

5. Do you owe debt? If so, are you using debt wisely, at affordable rates, and in ways that truly serve your mission?

Part 2:  Four Goals of a Capitalization Plan

With these answers in hand, an organization is better equipped to approach the four goals of a capitalization plan:

1. Achieving surpluses
2. Setting up reserves
3. The strategic use of debt
4. Periodic capital campaigns

The most important is achieving surpluses: spending less than you bring in. Many government contracts and foundation grants expect an organization to spend every dollar, which can make this difficult—but nonprofit organizations need profits in order to be healthy as enterprises, in the same way that for-profits do. One way to think about surpluses that might be helpful is that they provide savings. All healthy entities—households and enterprises—require savings. Another way to think of them is as an “existence fee” for nonprofits. In other words, if the organization does not have profits, its long-term existence will be in question, as will its ability to deliver its products or services reliably.

One might argue that the current state of play in the sector gives concrete evidence that nonprofits can indeed exist for a long time without profits. What we are positing is that if anyone who cares about impact digs under that financial “evidence,” they will quickly find that organizations are spending precious time patchworking their capacity and making suboptimal decisions that threaten to erode their effectiveness. We point readers to “Time to Reboot Grantmaking” by Michael Etzel of Bridgespan and Hilary Pennington of the Ford Foundation, which states, “It’s time to end Potemkin philanthropy that builds the façade of successful organizations that, in fact, teeter on the brink of collapse. We believe there is a better way—one that supports strong programs and strong organizations.”

We appreciate that this is easy to say, and hard to do—sometimes extraordinarily so. Our hope is that a well-considered capitalization plan will make it easier for nonprofit leaders be clear with both funders and staff about the purposes of various savings and their importance to the health and success of the organization.

Reserves are most useful when they are named, with policies that specify under what circumstances they will be used, and how they will be replenished. Because they are board-designated and not legally restricted, nonprofits have the freedom to re-size their reserves by moving money from one to another if needed. Establishing and demonstrating the use and replenishment of transparent reserves can be especially helpful for nonprofits fortunate enough to have sizable net assets—such reserves can inform stakeholders why the money is important, and demonstrate clearly that reserves are not simply about “hoarding” cash.

Debt is best used to solve problems of cash flow—when the money isn’t in yet, but it’s clear where it will come from and when—as opposed to patching a lack of cash (revenue). Rodney also discusses the use of a line of credit as a “peace of mind tool.” Debt can also be appropriate for other purposes such as equipment purchases and facility projects, where they can permit an organization to spread out payments over time.

Periodic campaigns for large sums of money that are capital, not revenue are important for when an organization needs to make investments in themselves as an enterprise. This could include physical investments like property improvements, or the costs of implementing programmatic or enterprise-level growth plans or operational changes.

We advise organizations to set modest goals, particularly for surpluses—which are vital to the long-term health and impact of the organization. Every year an organization has a surplus it strengthens its balance sheet, and overall viability. Every year it has a deficit it weakens its balance sheet, and moves closer to a possible failure to provide quality services and quality employment, or even possible failure to exist.

The third and final installment of the series will cover common challenges and pitfalls in nonprofit capitalization planning. Rodney will focus on why surpluses are rare and how we can think about them differently, and share thoughts on how standard financial information can help organizations and their supporters determine when a graceful exit might be best. We will also include a short list of resources on the subjects of nonprofit financial health and capitalization.