You can get an understanding of what philanthropic equity is via this column I wrote a couple of years ago. In short, “revenue” is earned income or fundraising done from donors who are making the donation so that the nonprofit can deliver their programs to the intended beneficiaries. “Equity” is donated money that is given by donors who are making the donation to support the growth of the nonprofit organization. In the for-profit world, customer money is revenue and investor money is equity.

George Overholser explained this concept in his seminal paper Building is Not Buying in which he termed donors providing revenue as “buyers” and donors providing equity as “builders”.

Four years ago, then president of Nonprofit Finance Fund Clara Miller gave George and Craig Reigel the go ahead to launch NFF Capital Partners. The group offers services to nonprofits that wanted to raise philanthropic equity. One critical aspect of the service is their Sustainable Enhancement Grant (SEGUE) accounting methodology. Since nonprofit accounting books all money coming into the organization as revenue, the team needed to build an alternate accounting system to track the philanthropic equity.

By 2010, NFF Capital Partners had led 11 philanthropic equity deals totaling $116 million and advised on another $196 million.

Their performance report shows that since initiating the deals, the nine nonprofits for which there is multiyear data have grown program delivery at an annual rate of 57% and grew revenue (excluding the raised philanthropic equity money, since it was properly accounted for as equity, not revenue) at an annual rate of 36%. This growth rate puts the organizations into the top 2% of fastest growing organizations in their cohort (organizations with budgets between $1 and $20 million).

The full report offers a short case study of each deal of which I’ll highlight two:

• DonorsChoose.org worked with NFF to raise $14 million in philanthropic equity with Omidyar Network and AIG as lead investors. To-date, DonorsChoose has burned through $6.5 million of their equity on the way to building their fee-supported business model, which is on track to achieving full sustainability. They now spend no time engaged in ongoing fundraising. Program delivery has grown at an annual rate of 58% and revenue has grown at a rate of 65%.
• Year Up raised $19.3 million in equity while working with NFF. Lead investors included Jenesis Group, Strategic Grant Partners and New Profit. Year Up depends on a combination of fundraising at the national and local site level as well as revenue from the corporate internships at which they place students. Since raising equity, they have grown students served by an annual rate of 31% and revenue at a rate of 18%. Year Up views themselves as now being at 74% sustainability with sustainability based on the degree to which local fundraising from the public and internship revenues cover total expenses.

The nonprofit sector suffers from a massive inability to scale. Since 1970, only 144 nonprofits have grown to surpass the $50 million a year in revenue mark. During that same time, 46,136 for-profits have cleared the $50 million hurdle. There is nothing fundamental about the nonprofit corporate structure that prevents growth. Yet accounting standards that fail to recognize nonprofit equity strip away the single most important building block to growing an organization. Without equity, an organization is forced to live on the revenue they gather each year and lack the ability to make meaningful investments in growth opportunities.

It is critically important that equity accounting be officially recognized in nonprofit accounting standards.

Nathaniel’s email to me made the following points:

• Nathaniel argued that the SIF grants were run of the mill, writing “The government just gave College Summit $3 million more dollars, about 20% of their annual budget. Big whoop.”
• He argued that the SIF did not do anything unique and different.
• He asked why I was focused on the intermediaries funded by the SIF rather than the subgrantees who would ultimately receive the grants.

In response I wrote:

When you write “the interesting thing about your argument is almost more about who were the intermediaries (and their approach to philanthropy) rather than who they’ll ultimately fund.” That IS exactly the whole point.

First, a quick pair of definitions (these are from a paper titled Building is not Buying by George Overholser):

• Builder: A donor who provides money to a nonprofit organization with the intent that the money be used to build the nonprofit organization.
• Buyer: A donor who provides money to a nonprofit organization with the intent that the money be used by the nonprofit to deliver products and services to the nonprofit’s beneficiaries.

(These roles are similar to the for-profit roles of investors and customers where Builder=Investor and Buyer=Customer, with the one difference being that Buyer’s buy goods and services that are delivered to other people rather than Customers who stuff for themselves).

The government has historically almost always played the role of Buyer. That makes sense. They are spending tax payer dollars so that products and services can be delivered to people who need them and thereby enhance the “public good.”

But the Social Innovation Fund is different. It very explicitly does not give money to nonprofits. It gives money to other funders. It has said it will select those funders based on their demonstrated “track record of success at identifying and growing high-performing nonprofit organizations.”

This means the SIF is the government trying to  be a Builder rather than a Buyer. BUT, the SIF was designed with the idea that the government probably isn’t the best entity to play the Builder role. So instead, the SIF is charged with identifying and funding other funders who have a demonstrated track record of being excellent Builders.

Why does this matter? Because today we are faced with a nonprofit sector that is populated with undercapitalized, underperforming nonprofits. Nonprofit quite literally live in a “starvation cycle” whereby they are constantly asked by Buyers to deliver products and services, but rarely are supported by Builders who will provide the resources they need to build and enhance their organization. What this means is that Buyers, including the government, don’t get nearly as much as they should for their money.

Imagine a for-profit sector that had customers, but no investors. You go to buy a cup of coffee, but the local shop uses a really old machine and sources only halfway decent beans. They also don’t spend much on training their baristas, so even though the people who work at the coffee shop are hard working, nice people, they simply haven’t been given the tools they need to succeed.

To make matters worse, in the nonprofit sector Buyers actually have the ability to restrict their gifts and tell the nonprofit that they simply are not allowed to use any part of the money the Buyer gives them to improve their organization. Local coffee shops can often succeed without a significant investor by devoting a portion of the revenue they receive from customers to buying better equipment, better beans and training their employees. But in the nonprofit sector, the customer/Buyer actually dictates what the nonprofit organization can use their money for! The typical donor actually wants the nonprofit to spend as little as possible on equipment, training, supplies, etc and instead just pump out as much of the halfway decent coffee (to jump back to the local coffee shop) as they can with existing infrastructure.

The SIF attempts to change all that. The SIF is the government saying that Builders are needed too. But the SIF faces a serious challenge because MOST funders in the philanthropic sector also refuse to play the role of Builder. MOST funders act as Buyers and restrict their grants so that the nonprofits they “support” can use little to none of their grant dollars to invest in their organizational infrastructure.

And then we have the gall to wonder why nonprofits aren’t more effective. What a joke.

But the SIF seems to have correctly diagnosed the problem. While funders who explicitly focus on playing the role of Builder are rare, the SIF has properly identified and chosen them as the funders best positioned to help the government finally play a Builder role.

While I’m not familiar with the approaches of every grantee (intermediary funder) of the SIF, I do know that the SIF says they want to fund Builder type funders (those who  have a “track record of success at identifying and growing high-performing nonprofit organizations”). And each of the four organizations I do know, New Profit, Edna McConnell Clark, Venture Philanthropy Partners and REDF (which collectively received 44% of all the SIF funds) all rank as some of the leading practitioners of the Builder approach to philanthropy! So the SIF didn’t just get the concept right, they executed correctly!

In your email you say “The government just gave College Summit $3 million more dollars, about 20% of their annual budget. Big whoop.” But that’s not at all what happened. The SIF gave a Builder funder a chunk of cash and that Builder chose College Summit to fund. Not just to pay them, as a Buyer would, to deliver more of their programs, but to invest in Building the strength of the College Summit organization.

This means College Summit can get better at what they do. Not just do more of what they already do, but improve and grow so they can do exponentially more of what they do and do it better.

While College Summit and a few other subgrantees were “preselected,” the SIF actually had the guts to really follow through on the idea that the grantees (the intermediary funders) were the best ones to select which nonprofits are best positioned to receive Builder grants. The majority of the SIFs grants were distributed based on the SIF’s analysis of the grantees (intermediary funders) ability to identify and grow great nonprofits, not on the SIF’s assessment of each potential subgrantee (which have yet to be chosen by the intermediary funders).

If we had a better capitalized nonprofit sector, a philanthropic sector that included a far greater proportion of Builder funders, then Buyer funders – and importantly the government, given the Buyer role it typically plays –  would have more robust, higher performing nonprofit organizations from which they could Buy social good.

Using the coffee shop analogy, this would mean that Buyer/Customers could finally have access to coffee shops that used top of the line equipment, fresh roasted, top quality beans and were served by well trained baristas.

As far as I’m concerned, the SIF hit the ball out of the park today. They did NOT simply shovel Buyer money at some cool nonprofits. They did NOT simply allocate the money based on a bureaucratic earmark process. They actually executed on their mission of providing Builder funds. When we talk about their $50 million being small, it is because we are measuring it against all donated dollars. But when we measure it as a proportion of total Builder dollars, $50 million is serious cash.

By George Overholser

• Someone recently defined nonprofit “mid-caps” as organizations with revenues in the $5 million to $25 million range.

We need to keep in mind that the definition for for-profit mid-caps is 200 times as big:  revenues in the $1 billion range.

This matters because there are metaphors flying around that we need our nonprofit mid-caps to provide more financial disclosure to the “capital market”, just like for-profit mid-caps.

This is the equivalent of asking a guy who owns a couple of pizza restaurants ($5 million in revenues) to begin publishing detailed quarterly public reports of his financial and quality assessment results.  Problem is, his office is the kitchen table, and he needs to get up at 6am every morning to roll the dough.

Wall Street is the wrong metaphor for an online “nonprofit capital market”.  Wall Street only works for companies that are literally hundreds of times bigger than typical nonprofits.  Wall Street companies get easy access to equity, precisely because they are already so advanced that they can afford to provide exceedingly high levels of financial transparency.  But the vast majority of firms (for-profit and nonprofit alike) are nowhere near the size required to afford the cost of making these types of disclosure. That’s why the vast majority of firms are capitalized privately, by intimate investors who get to know them personally.

Let’s not kid ourselves into thinking that strategic equity-like investments should be made based on the snippets of data that an exhausted executive director posts on a web site.

If information is to be shared online, the better metaphor is Amazon.  The better information to share is more akin to marketing information than to investor information.  Keep it simple:  What am I buying with my donation?  What gets done as a result?  What does it cost?  And… for those very few that have gone through the arduous and expensive process of scientifically documenting impact, yes, what is the impact?

DonorsChoose is a great example of this.  Check it out:  a highly intimate and transparent giving experience that has no need to share information about the financial health of the DonorsChoose enterprise, management team, strategic plan or theory of change.

Simply “asking harder” for information does not address the issue.  The problem is not one of candor.  Rather, the data does not exist, and cannot be afforded by such small and stressed-out organizations.  Asking harder merely adds to the trauma.

If a prospective investor comes along, who is prepared to write a big equity-like check, then have a face-to-face meeting, so that real due diligence can take place.  In the meantime, I would love to see online marketplaces focused on products and services… like Amazon and DonorsChoose!

The Clearinghouse is interesting because of the way it offers some of the attributes of a stock exchange. There has been a lot of talk in philanthropy about social stock exchanges, but I’ve often found the implementation of this concept of little interest. This is because when most people think of a stock exchange, they think of the prices of stocks moving up and down as the primary characteristic. A social stock exchange which attempts to mimic the pricing elements of a stock exchange is interesting, but I’ve yet to see an implementation that is particularly exciting. Instead, stock exchanges are valuable not only because they publicly reveal prices, but because they have certain requirements for organizations to be listed and ongoing requirements to stay listed.

Once an organization is listed on a stock exchange, it must adhere to higher levels of public disclosure than a non-listed company. Being listed on a stock exchange is called “going public” and a listed company is a “public company” as opposed to a non-listed or “privately held” company.

This all matters to philanthropy because the organizations listed on the new Social Impact Exchange are offering public access to documents such as due diligence reports, business plans and the results of independent evaluations (it appears that currently there are not standard documents that all listed organizations must have, but see the documents listed for the nonprofit Ways to Work as examples).

My friend George Overholser, has often pushed back on my urging for nonprofits to share more information about themselves publicly. George’s point is that most nonprofits are the equivalent of privately held companies, who may be damaged if they share too much of their internal issues with the public. While I’ve generally thought that nonprofits should have a higher required level of transparency than privately held companies, George’s point has always resonated with me. With the advent of the Social Impact Exchange, we have the beginning of a mechanism whereby a nonprofit that is ready to “go public” can list their organization and in exchange gain access to a wider range of philanthropic investors.

In addition, the Exchange plans to only list organizations who have demonstrated extremely high levels of impact and scale readiness or have demonstrated a significant level of effectiveness, and are increasing their capacity for scale readiness (groups qualifying under each standard are identified separately). This means that if the Exchange can establish credibility for their vetting process, 1) organizations who get listed will gain a marketing advantage due to their “making the grade” and 2) donors can have an increased level of confidence in Exchange listed organizations.

The Social Impact Exchange is more than just a list of nonprofits. It also hopes to be a hub for related research, publishing, education and training as well as an annual conference, business plan competition and regional meetings.

While this effort is still in its infancy, I think the organizers have gotten some key elements right. With the high profile funding from Robert Wood Johnson Foundation and the involvement of Duke University, the Social Impact Exchange is one to watch.

Charities Should Be Held to ‘Philanthropic Equity’ Standards
By Sean Stannard-Stockton
August 20, 2009 | Link to Chronicle of Philanthropy

It is time for nonprofit accounting standards to recognize the concept of "philanthropic equity."

For too long, donors have looked at nonprofit financial statements and believed that as much money as possible should be spent on programs and as little as possible should be spent on the organization itself. This logic is fundamentally flawed because, no matter how great a program is, only a high-performance organization can deliver, expand, and improve effective programs.

The fact is nonprofit groups need two kinds of cash flow: revenue and equity. Recognizing the distinction between revenue and equity is critical to building great organizations. Revenue is cash flow delivered to an organization in exchange for execution: delivering goods and services.

Equity is cash flow delivered to an organization for the purpose of building the organization. Without the ability to account for philanthropic equity, it is simply not possible to distinguish between donations that keep a nonprofit running and those that are intended to build the organization.

Like a for-profit company that offers a great product but doesn’t have the resources to invest in great management, technology, and infrastructure, a nonprofit organization without equity is doomed never to fully realize its potential. Just as some people are customers of a company and others are investors in it, donors can play the role of providing nonprofit organizations either revenue or equity, or both. But for donors to evaluate a nonprofit group’s need for equity and the effectiveness with which it uses that equity, the two forms of cash flow must be recognized separately. The current nonprofit accounting standards ignore the existence of equity and treat all cash flow as revenue.

High-performing nonprofit groups need equity to grow and improve. Unfortunately, nonprofit groups are systematically starved for equity capital. Since we tend to get those things we measure, it is critical that we begin to explicitly measure equity on nonprofit financial statements.

A new equity-like methodology, called the "sustainable enhancement grant," has already been deployed successfully among several high-performing nonprofit groups to help shed light on their finances in a way that allows them to attract equity-like philanthropic donations. The system was developed by the Nonprofit Finance Fund and it has been well vetted by leading law firms and accounting firms. Now it is time to build those concepts into standard nonprofit accounting guidelines.

Warren Buffett is known to believe that evaluating the amount of profit a company makes (what we in the nonprofit world might refer to as results) is not enough. To truly understand how well a company is performing, Mr. Buffett looks at the return on equity. This measure reveals the performance of a company in relation to the amount of capital invested in building the organization. The nonprofit world needs a similar measure. If we hope to encourage donors to truly invest in nonprofit groups, they must be able to understand how their "equity investments" are performing.

The need for this change is urgent. The newly created government Social Innovation Fund is designed specifically to increase the flow of equity-like capital to nonprofit groups. The bill authorizing the fund requires that the money be used to build the capacity of nonprofit groups to copy and expand proven programs. But without official accounting recognition of philanthropic equity, it will be impossible to evaluate whether those capital flows actually are used to effectively build the grantee organization or simply to finance operations.

According to the White House, the Social Innovation Fund is all about "finding and scaling the best social innovations." This is an important and achievable goal. But "scaling" a nonprofit group requires more than just making big grants. It means offering capital that is explicitly earmarked for building the organization itself, not for spending to deliver programs. But without philanthropic-equity accounting, only the handful of organizations voluntarily using the sustainable enhancement grant accounting system have the ability to actually account for how effectively they are using grants intended to help them expand.

There is too much at stake for donors to continue giving more than $300-billion a year without a better understanding of which nonprofit groups are using their money to build sustainable organizations and which are not. It is time for the Financial Accounting Standards Board to recognize philanthropic-equity accounting.

A high performance nonprofit is a very well run organization. It has outstanding leadership, clear goals, an ethic of monitoring performance and making adjustments as needed, and it is financially healthy.

A high impact nonprofit is one whose efforts have been proven to cause sustainable, positive change.

Impact can be seen only in retrospect. Often many years later. Performance can be directly observed.

I think high impact nonprofits are the holy grail of philanthropy. But like any holy grail, it is something to journey towards, not something you demand now.

Guess what, nonprofits need funding during their entire lifespan as they head towards high impact status. The ones that get there are not the ones that have the best programs, they are the ones that are the highest performing organizations. High performing organizations are robust and flexible enough to dump programs that don’t work and adopt those approaches that work best. Weak organizations that happen to have a great program are not able to deliver the program with fidelity, are not able to scale the program and are not able to adapt to changing conditions.

As a field, philanthropy needs to focus on indentifying and funding high performance nonprofits. This was my point during my debate with Paul Brest earlier this year. This is my point when I reject overhead expense ratios as a relevant evaluation metric. This is my point when I ague that nonprofits should pay their employees better. This is my point when I call for “philanthropic equity” funding. This is my point when I argue that the Social Innovation Fund may encourage foundations to supply growth capital.

Currently, the field of philanthropy rejects performance in favor of evidence of impact. Philanthropy likes to talk about great programs, but forgets that only high performance organizations are in position to deliver great programs consistently.

It is time for us to reject the idea that great programs run themselves.

[The Social Innovation Fund] makes the government basically a grantmaker, giving away $50 million per year (which is not much as funders go). Sean points out that the original idea was that the government would find these worthy nonprofits and give the money to other funders to then pass on, after a match.

That’s definitely better, but still, either way, here’s my question: How is this in any way different than how things happen already?

Every foundation in the United States is essentially already doing what the White House office will be doing: trying to find the most promising grant recipients.

I do not understand what the fanfare is here, when what really appears to be happening is that a new funder is entering the mix. Yes, that’s good — but not shout-it-from-the-rooftops good.

Brad’s not the only person asking this question. If it is done wrong, the Fund will likely be a bureaucratic nightmare as Jeff Trexler recently suggested. So here’s my argument for why the Social Innovation Fund is a big deal if it is done right.

• The Social Innovation Fund is the first meaningful incentive for large foundations to provide growth capital to nonprofits.
• It provides serious “carrots” to participating foundations, but also empowers itself to “rate” those foundations. This should create the first meaningful incentive for foundations to compete to be viewed as the “best” funders.
• The Fund refocuses philanthropy from supporting programs to supporting nonprofit organizations.
• The Fund explicitly makes clear the role of the government as an “exit strategy” for philanthropy.
• The Fund offers meaningful incentives for the field of philanthropy to embrace a culture of knowledge sharing.

If you read this blog regularly, you can see that the points above are pretty much my wish list for our sector. Here’s why I think each point is true as long as the Fund is run in accordance to the policy recommendations of America Forward and follows the letter and spirit of the bill authorizing the Fund.

The Social Innovation Fund is the first meaningful incentive for large foundations to provide growth capital to nonprofits.

The Fund is providing cash grants to grantmakers. Most grantmakers are stuck with the endowment they have and do not have access to additional funding. But the Fund requires that grantmakers use this money (plus matching funds from the foundation’s endowment) to provide growth capital and capacity building grants to nonprofits. In addition, the Fund sets the government up as a long term exit strategy so that the grantmakers do not need to support the grantee forever (see below on “exit strategy”.)

It provides serious “carrots” to participating foundations, but also empowers itself to “rate” those foundations. This should create the first meaningful incentive for foundations to compete to be viewed as the “best” funders.

While offering the “carrots” above, the Fund also requires that grantmakers make a compelling case that they have an evidence based decision making strategy and provide specific measureable outcomes related to the areas they seek to support. Since the Fund cannot make grants of less than $1 million and it only has $50 million, it cannot select more than 50 grantmakers to work with. Since it is allow to make grants as large as $10 million, the final list will be between 5 and 50 grantmakers. That’s a list that foundations are going to want to be on. Even those that historically have not focused on providing growth capital.

The Fund refocuses philanthropy from supporting programs to supporting nonprofit organizations.

The language of the bill authorizing the Fund presumes that the role of funders helping to support social innovation is to provide growth capital. This isn’t terribly surprising when you realize that America Forward was convened by New Profit, which is one of the leading growth capital funders. This shift from foundations as designers of programs who contract execution out to nonprofits to foundations as providers of growth capital to the performance driven nonprofits represents a fundamental shift in philanthropy and one that I am a big advocate for.

The Fund explicitly makes clear the role of the government as an “exit strategy” for philanthropy.

The Fund become the “venture philanthropy” arm of the US government. But in promoting the Fund, everyone from President Obama on down has referenced the successful scaling of Nurse-Family Partnerships. The government did not care so much about NFP when it was a small, local program. But now that it has gained scale via the intentional providing of philanthropic growth capital from foundations, the 2010 federal budget is calling for $8.5 billion over the next ten years to finance nurse-family visitation programs.

So the Fund begins to make explicit the interest the government has in effective social innovations reaching a scale where the Federal government can step in to provide funding. This model wins with social liberals who love to see the government provide effective social benefits and it wins with social conservatives who love to see the government contract with privately developed and managed programs to execute social benefits. It also wins with foundations who can see that if they expend resources to scale effective programs, the government will step in to provide funding and the foundation can exit the relationship with the grantee. Is there an unlimited capacity for the government to provide funds? No. But government resources swamp private philanthropic resources and effective programs like NFP save the government money.

The Fund offers meaningful incentives for the field of philanthropy to embrace a culture of knowledge sharing.

The language of the bill authorizing the fund requires that nonprofits that receive subgrants from the grantmaking partners be committed to the use of data collection and evaluation and be important contributors to knowledge in their fields. It requires that when making grantmaking decisions the grantmakers consult with a diverse cross section of community representatives in the decisions, including individuals from the public, nonprofit, private, and for-profit private sectors. And it mandates that the Corporation for National & Community Service that will operate the Fund shall maintain a clearinghouse for information on best practices resulting from initiatives supported by the grantmakers and their grantees.

This is important, heady stuff. If executed properly with vision and integrity, the Fund may mark a major turning point in the field of philanthropy. But it is easy to imagine that the fund will not live up to its potential. This is a big project and there are going to be many competing interests clamoring for attention. It could turn into a bureaucratic mess of grant dollars being handed out in a rote manner that relates more to political connections than anything else. This is the nightmare that Jeff Trexler worries we’ll see. I hope he’s wrong. I think the people running the Fund want to do the right thing and recognize the opportunity they have. Let’s all commit to support this important endeavor.

My sense at this time is that the mismatch is based not on an intentional decision by the President to run the fund in a different way, but by a lack of understanding by the President of the role of the fund (which is understandable since the Innovation Fund can’t be very high on the President’s priority list).

One reason for believing this to be true is that as I understand it, the Edward M. Kennedy Serve America Act that authorizes the Social Innovation Fund requires grants from the Fund to go to grantmaking organizations. The bill clearly states that only “covered entities” may receive funds and it defines “covered entities” as “grantmaking institutions.” So as far as I can tell, the President’s description of how the Fund will be managed that he gave at Tuesday’s press conference runs counter to the bill that authorizes the fund.

Look, just to be clear, I’m not suggesting that any fishy is going on. I’m not saying that the Obama administration is doing anything wrong. I think that we’re operating in a space that few people understand and which even people who understand have a hard time explaining well. I expect that over time administration will figure out how to describe the fund more clearly and accurately.

I think this fund is going to be a big deal. It might end up being a really big deal.

Interestingly, President Obama described how the fund would work in a way that I think would be a huge mistake and is not in line with indications we’ve had to date of the structure.

President Obama said:

“We’re going to use this fund to find the most promising non-profits in America.  We’ll examine their data and rigorously evaluate their outcomes.  We’ll invest in those with the best results that are most likely to provide a good return on our taxpayer dollars.  And we’ll require that they get matching investments from the private sector — from businesses and foundations and philanthropists — to make those taxpayer dollars go even further.”

The implication in this statement is that the Innovation Fund, with just $50 million, is going to set out on their own to find promising nonprofits, evaluate them and then make restricted grants to these nonprofits that will only be given if the nonprofits can find matching grants from the private sector. In other words the government run fund would identify the innovative organizations and then demand that private philanthropic dollars are matched against the Innovation Fund decisions.

This would be crazy.

If this is what the Innovation Fund is, then it is just a small foundation that isn’t really doing anything special. But I think President Obama doesn’t really fully understand the Innovation Fund.

Let’s instead look at what America Forward said about the announcement. America Forward is important because they are the group that made the policy recommendations that led to the Serve America Act, The Office of Social Innovation and the Innovation Fund. They have been the intellectual force behind these policy decisions.

Note how America Forward presents the structure of the Innovation Fund differently than President Obama:

“Administered by the Corporation for National and Community Service, the Fund will provide grants to existing grantmaking institutions that will in turn invest in growing innovative, results-driven nonprofits. Both grantmaking institutions and the nonprofit grantees will match the Fund’s investment, generally resulting in a 2:1 match.”

Whew! That’s much better. Under this model, the Innovation Fund is simply identifying smart private sector funders, making grants to the funders, who would then pick which nonprofits were innovative, effective and ready to scale. The government gets to put money to work via smart funders focused on effective solutions. They also get to watch the development of the grantees as they scale and will be in a great position to make significant funding decisions once some of the effective organizations have gone national. The case study for this is the successful scaling of Nurse Family Partnerships (by private sector funders) and the $8.5 billion that the 2010 federal budget calls for to fund these types of activities.

I think this is all really exciting. I think that the Innovation Fund is on the right track. It is great to see Melody Barnes assigned to run it. I believe that structurally the Innovation Fund will represent something new and serve as a conduit that helps start to streamline the capitalization of of effective organizations as they grow. I highlight President Obama’s (hopefully) incorrect description of the Fund to highlight 1) that the structure of the Fund is what makes it important, not the $50 million which frankly is not much money to start something like this and 2) to point out that as much as there are a lot of forces moving in the right direction to create more effective social capital markets, we’re still in the confusing market creation period. We’re going to get some things wrong. I hope we get the Innovation Fund right.

So I’m going to simply take another shot.

The stated goal of the Social Innovation Fund is to “identify the most promising, results-oriented non-profit programs and expand their reach throughout the country.” They plan to do this via effectively outsourcing the selection of nonprofits by “awarding competitive matching grants to social entrepreneur venture funds.”

This means that the Social Innovation Fund will not need to utilize metrics that attempt to capture how much social value a nonprofit is creating (see note at end of this post). They are outsourcing that decision making process to the venture philanthropy funds. But the Social Innovation Fund will need to track the degree to which the nonprofits in the program are effectively scaled. The degree to which they take their “promising, results-oriented programs” and “expand their reach throughout the country.

What I’m doing in framing the issue this way (and what I think the Social Innovation Fund should do) is make the simplifying assumption that the nonprofits selected by the venture philanthropy funds they work with are creating cost effective social outcomes. This means that the grantee nonprofits are running organizations that can create at least $1 of social good for every $1 in expenses.

In his comment to yesterday’s post, George Overholser suggested that Nurse-Family Partnership (a favorite case study of an effectively scaled nonprofit) is saving taxpayers $6 for every $1 in donations to NFP (I strongly believe that saved tax dollars is not the best way to measure social value, but it can be useful). But it is clear that the actual number might be more or less (which George points out). But the point is that NFP is almost certainly creating cost effective social outcomes.

If the Social  Innovation Fund makes this simplifying assumption, then it can track the performance of venture philanthropy funds by measuring how successfully the grantees of the fund are scaled. Note that this does not just mean tracking revenue growth. It is easy to make a $5 million a year organization double in size. Just give it another $5 million. So in order to track effective growth, you must measure how an organization turns “growth capital” investments into self sustaining program execution growth.

In the comments to yesterday’s post, George Overholser laid out the rationale for a measure called ROPE, Return on Philanthropic Equity. I’m sure their are other approaches.

My point in all of this is that the Social Innovation Fund is in the business of scaling organizations that work, not identifying which ones work. Therefore, they do not need to look at outcome measurements, they need to track the rate at which the organizations they co-fund effectively scale.

So my question again is: How should the Social Innovation Fund evaluate the historical performance of philanthropic funders? With the area of measurement being the degree to which the grantees of the venture funds effectively scaled.

Postscript: The measurement of social value creation is complex, difficult to prove, subject to subjective interpretation of value, and likely rooted in measurement frameworks not connected to financial analysis.

Measurement of organizational growth on the other hand, is relatively easy (if the accounting is does right), simple to prove, not subject to interpretation and obviously rooted in financial analysis frameworks.

$1 given to a nonprofit might result in negative social value (if the program activity reduces quality of life in the focus area), social value of between $0 and $1 (if the program activity increases quality of life, but not by as much as other approaches), or more than $1 (if quality of life increases by more than could be achieve with other approaches).

So the simplifying assumption that I’m making in this post is not that the venture philanthropy fund are finding the best performing nonprofits in terms of social value creation, but that they are finding organization that produce more than $1 of social value for every dollar of revenue. While we obviously want to scale the best organizations, all organizations that create cost effective social value are organizations that should be scaled.

Let me validate many of the comments here based on our experience launching and taking GlobalGiving to scale.

George is right that it takes $10-30 million to get something like this to scaleability and sustainability. And, per George, I am also convinced that one reason that we have succeeded thus far is that we treat growth capital separately from donations to projects from a financial (and operational) management point of view.

Chuck is right that it takes multi-year funding from a consortium of funders to make something like this work. Chuck’s success is also testimony to the power of a strong lead funder. So far, we have been fortunate enough to have patient capital from a group of leading foundations, without which we would not be here. (Though without a doubt, this patience will be tested by the current economic climate, even though we grew by over 200% last year.)

Mario makes a fundamental point: “In contrast with the private sector, there is a great need for the “philanthropic investor” to be engaged, even directly involved, and emotionally affiliated.”

The bottom line is that there is currently no single bottom line for all philanthropic funders- even the most advanced ones. The $64,000 question is whether this is even possible – either theoretically or in practice. The good news is that there are some great people working on this (including many of the commentators on this post.) I hope they succeed. But the jury is still out, and I predict that much additional experimentation will be needed in the years ahead before we find the right approach(es).

On one hand, I don’t believe it’s wise for a funder to withdraw completely from the “What sorts of programs work?” discussion. Many programs simply don’t work, and the state of knowledge about effective programs is very poor – just because a program has raised a lot of money, has an excellent reputation, or even has excellent people working on it doesn’t mean it’s an effective program. “Investing in nonprofits” has to include separating better from worse nonprofits, and I believe part of that evaluation should include what they do and whether there’s a case for it as an effective program.

That said, we see our primary role as identifying excellent charities with strong track records and funding them – definitely not as “subcontracting out” our own programs based on our own theories of change. More thoughts on this idea here and here.

I’ve taken the liberty of posting below the content of the first link Holden refers to in his last sentence. This post was in response to a question I had emailed him in April 2008:

Sean asks (via email):

What’s your view on whether funders should do research on techniques and then fund organizations that use those techniques or do research on organizations and let them decide on techniques? I was intrigued with your education research post, but was wondering if it might make more sense to find smart dynamic nonprofits who will figure out the best techniques to use and change strategy as more information becomes available.

My literal response is that it depends on the funder’s priorities and techniques – I don’t think there is much to be gained by debating the approach “funders” should take in the abstract. But I want to share how we deal with this question, as naive funders (i.e., not experts in the issues) aiming to serve more naive funders (i.e., individual donors), because we do have a specific philosophy on it and we’d appreciate feedback.

My ideal is to fund at the highest level I can have confidence in, i.e., delegate as many decisions as possible to to someone who I feel confident will make those decisions well.

So, my ideal would be to donate not to a charity, but to another funder. If a major foundation, such as the Gates Foundation, could convince me that they consistently make decisions using (a) a strong process, (b) good reasoning, and (c) subjective/philosophical values that are close to mine, I would give to them and let them do the rest (and get rid of our own, now redundant overhead). This was one of the first things we tried when GiveWell was still a part-time volunteer club. What stopped us was that we couldn’t find a single foundation that publicizes substantive information about how it makes its decisions, why it chooses to do A instead of B, and what evidence there is regarding its past and likely future impact. We couldn’t be confident in the institutions without such information; we couldn’t think of a way to get them to share information, since such institutions generally don’t have incentives that we can affect. So we moved on to trying to find great charities.

Again, the goal was ultimately to find a great organization – one that’s better at what it does than we could ever be, and can make its own compelling, evidence-based case for its effectiveness – and give with no strings attached. In some cases, we found exactly this: for example, the Nurse-Family Partnership’s outcomes evaluation is available via peer-reviewed publications, its basic model is clearly described on its website, and it provided documents to fill in gaps in our understanding. PSI was a similar case: after some independent checks on its estimates, we felt we could trust its process as a whole, even for activities we haven’t researched.

In other causes, the strongest applicants could provide some pieces of the puzzle, but not the full top-down case for why their approach was the best available. That’s where we had to start looking on our own for information about what approaches are likely to work, and pick organizations that fit with what we had found. There’s a spectrum here. KIPP gave us about 60% of what we needed to have confidence in it, and after some independent analysis, we ended up feeling that it was our best bet. By contrast, our Cause 2 (global poverty) applicants gave us so little to go on that we ended up betting on an approach, more than an organization.

Between blind faith and micromanagement is conditional confidence: trusting an organization to make decisions because of an evidence-based case that they can make them well. That’s our ideal; when it isn’t available, some degree of micromanagement (i.e., picking an organization based on its approach) seems preferable to blind faith.

Now Mario Marino of Venture Philanthropy Partners adds a very insightful comment:

Sean, you and the posting that followed present a solid case for “capital market philanthropy.” But, to be honest, I don’t see the world as bifurcated as you do. Yes, there is a distinction to be made between those who look for great nonprofits in a general issue area (e.g., education) vs. those who have a specific goal and then try to find nonprofits that can help them achieve that goal. However, I have seen good examples of funders pursuing each of these approaches and advancing what I consider to be “capital market philanthropy.”

In my mind, we advance capital market philanthropy every time we help to steer capital preferentially to nonprofit organizations that are clear about what they’re trying to accomplish and have evidence (qualitative and quantitative) that demonstrates they are making progress toward those goals. We do even more to advance capital market philanthropy when we help nonprofits to clarify their goals and collect evidence of progress?and then make this information widely available to other potential investors. I see a wide and growing array of different grantmakers—from large, established foundations like Hewlett to newer, comparatively small funds like the one I co-founded—taking both of these approaches.

This is a time when we need many experiments. That donor investors care about important societal outcomes and are willing to make enduring commitments to see their efforts through (e.g., Seibel) is a great thing. The field needs an Edna McConnell Clark to illustrate that it is possible to transform a more traditional, established foundation. It needs a Hewlett Foundation to set a standard for the seriousness and strategic way in which philanthropy can be approached. It needs Acumen, New Profit, NFF, SeaChange, GPN, and others to succeed?for each presents a compelling model for others to emulate and adapt. Just as it took a long time to create the continuum of capital-allocation models we now see in the commercial sector (including some models that have clearly done more harm than good), the charitable sector is now engaged in a long process that might outlive most of us. I’d hope we look at these groups (and others yet to emerge) not as the definers of philanthropic capital markets but rather as pilots and demonstration efforts that with their success will stimulate further innovation, effectiveness, and efficiency.

Producing innovative, effective, and efficient capital markets for the nonprofit sector will take many things. For example, it will take results. Sean, you put together a good list of organizations and were kind enough to include Venture Philanthropy Partners on that list. I believe these organizations are allocating capital in thoughtful ways. But perhaps the most important contribution that these groups are making is that they are “nudging the system.” For example, these and other groups have nudged some established foundations to think more in terms of making long-term investments in organizations and their leaders—rather than just making program grants. This mindset—and certainly the terminology—was considered heresy by many as recently as 15 years ago.

Second, philanthropic capital markets require, well, capital. In spite of the many accomplishments of the organizations you cited and the nonprofits they?ve invested in, the sum of the capital they?ve raised remains but a speck within the universe of philanthropic monies. Although I believe these funds will continue to grow, I fear it may be incremental, not quantum or viral.

Third, if we are somehow able to increase the flow of capital, we will need to couple that with an increase in the flow of talent—from entrepreneurial to executive management.

Fourth, we need to be sure that even as we pursue greater efficiency in capital allocation, we should never try to squeeze out the human element. In contrast with the private sector, there is a great need for the “philanthropic investor” to be engaged, even directly involved, and emotionally affiliated. This phenomenon simply does not exist in the same way in the commercial capital markets. In the private sector, you deliver on or exceed your promised internal rate of return (IRR) and folks love you forever, with or without direct engagement—and with little questioning. The Bernard Madoff case stands as a dramatic confirmation of the detachment of investors in the private sector. On a small scale, I believe the Donors Choose model is highly instructive in that they seem to have found a good balance between “high efficiency” and “high engagement.” They could be looked at as the “high-tech/high-touch” example in philanthropy.

Sean, my thanks to you for starting this conversation, and to George Overholser, Chuck Harris, and Jeff Berndt for adding their perspective. 

I wholeheartedly agree that one of the big problems we need to solve as a sector is how to find ways to scale highly effective nonprofit organizations, so I applaud you for raising this question and also for highlighting the power dynamic that can often exist between funders and grant recipients.  (I particularly like George’s reference to the need to be a “chameleon”, which captures the issue very nicely).

At Acumen Fund, about two years ago we realized that we were in a position for a major scale-up of our work, and we also recognized that the best way to do it would be to raise a large pool of unrestricted philanthropic capital that would take us to the next level.  We set out to raise $100M over two years in unrestricted capital in May of 2007, and by the end of 2008 we raised $85 million against this goal. 

One of my reflections having led up this effort is that individual philanthropists are typically much more prepared than institutions (foundations and corporations) to make large, long term, multi-year, unrestricted gifts.  (That said, there are some institutions that are exceptions to this rule, and I do believe that when programmatic goals of a nonprofit align closely with those of a foundation, large gifts with some restrictions can provided needed growth capital that allows for the kind of organizational investment that growing nonprofits need to make.)

Where things get really tricky is when a nonprofit that might be ready for tens of millions of dollars of growth capital (the $10-$30M that George Overholser suggests is a good reference point) finds itself mostly able to raise programmatic grants (often narrowly restricted) in $50,000-$100,000 increments from foundations.  Programmatic grants like this can create the two-headed hydra of not having sufficient funding for “overhead” (a.k.a. non-program staff), combined with the communications, relationship and reporting challenge that can come with having 100 individual $50,000-$100,000 grants (an absurd number, but this would get you to $5-$10 million) – the “chameleon” problem.

The irony is that in other lines of work – venture capital; executive search; etc. – being able to find and invest in a world-class team of people is seen as THE differentiator between good and great firms.  Yet all too often, foundations seem unwilling to invest in people and organizations, instead seeing nonprofits as a means to a programmatic end. 

The problem with a world in which the most proactive, risk-taking philanthropists are individuals (rather than foundations) is that it has the potential to limit severely the types of new nonprofits that will be successful at growing to scale – namely, the winners will be those organizations that are run by individuals who are capable of building strong and deep relationships with ultra high net-worth individuals. Nonprofit CEOs who can do this bring together a unique combination of skills, but if this is only real way for anyone looking to grow a new nonprofit, then we as a society have a problem. (though large scale retail fundraising using Web 2.0 tools is a potentially interesting solution).

The potential I see is to have foundations bring together both know-how about what it takes to solve major social problems AND a risk appetite to put capital behind organizations (and not just programs) that have a real chance at building those solutions. 

For now, at least, it seems like we’re coming up short on the appetite for risk and for openness to the idea that investing in great teams and building great institutions will be what brings forth the next wave of groundbreaking nonprofits.

Chuck Harris:

On behalf of SeaChange Capital Partners, let me add to the excellent comments from George Overholser and Jeff Berndt.

At SeaChange Capital, we also take an enterprise-centric approach, believing that outstanding entrepreneurs and their boards and management teams deserve and require unrestricted, multi-year philanthropic support in pursuit of significant increases in impact. Certainly this is how great companies are funded, and while acknowledging imperfect mapping between business and social enterprise, we do believe the equity investor’s mindset is applicable to both sectors.

We add to this the conviction that, as the social problems faced by children and youth in our low-income communities are enormous in scale, at least some of the responses need to be of scale as well. This suggests that the funding required from the philanthropic sector, often and ideally in partnership with government, needs to be quite large, larger than any single funder can provide. So we have taken on the assignment of supplementing our own resources with those of a national network of wealthy individuals and families who see the need to act collaboratively, with SeaChange Capital conducting significant due diligence (including utilizing prior research done by others willing to share their insights) and working to arrange the multi-party financings.

Yes, only time will tell if well-capitalized nonprofit enterprises can effect meaningful social change. I would suggest that results from the handful of youth-serving organizations that have achieved financings of this nature (see, for example, Teach for America, College Summit, Year Up, Youth Villages, Citizen Schools) support our thesis.

Thanks for engaging the conversation.