I’m on vacation this week. This post originally appeared on March 3, 2007. I wrote this well before the Some Nonprofits Just Suck debate exploded. The fact that this post has been so widely read and a debate on the subject recently raged for two weeks shows that as a community, we have some important principals we need to hash out.
Nonprofits vs. For Profits
Employees of nonprofits, who toil away at below market rate pay scales (a scandal), must get really tired of the “new donors” who are demanding that they act more like for profit businesses and treat them like they aren’t very smart.
I think that the trend towards venture philanthropy, social enterprise and market-based solutions is very positive and should be encouraged. I think that it is terribly exciting that the Silicon Valley tech elite and the New York centered, “masters of the universe” financial wizards have turned their attention to philanthropy. At the heart of the technology and financial revolutions that have taken place over the past few decades is a focus on innovation. Applying this same innovation to improving the state of the world is going to have a dramatic impact.
But before we get carried away and start assuming that Google knows more about global warming than the Environmental Defense Fund, that Bill Gates knows more about vaccines than the World Health Organization, or that the founder of an online auction company knows more about the poor of India than Mother Theresa, let’s make sure these new donors know that nonprofits function differently than for profit businesses for a reason:
Nonprofits are paid by one customer (the donor) and deliver products and services to another customer (the cause there are advancing). This makes things tremendously complicated. I advocated recently that nonprofits need to remember that “the customer is always right” (See The Agitator’s post on when this isn’t true, which I completely agree with). But what happens when one half of the customer base is demanding something that hurts the nonprofits ability to serve the other half? Nonprofits do not exist to serve donors; they exist to serve a cause. The new donors need to understand that nonprofits will almost always know more about what is best for the cause than the donor does. So cut them some slack and don’t tell them to change until you’ve really done your homework.
Administrative expenses are not evil. There is such a thing as waste in both for profit and nonprofit financial statements. But the administrative expense by itself is not going to tell you that. I would venture that The Four Seasons hotel has higher administrative expenses than Motel 6. Does that mean Motel 6 is a better hotel? Sometimes great businesses have to spend more money to produce their product or service than their lesser competitors do.
Market based solutions are great when they are appropriate, but they aren’t always appropriate. Innovations like carbon trading are great alternatives to scolding people to think more about the environment. But the nonprofit sector exists because there are things people want that for profit businesses don’t deliver.
Markets are great when society is fine with whatever outcome is generated. If markets decided that athletic shoes are going to cost $120, you might think that is too high, but few people will believe it is “wrong”. But if society is unwilling to accept a market outcome (for example, electricity prices so high that elderly people can’t afford to heat their homes and die as a result), than you must impose some sort of modification to the market system. You can’t ask the “free market” to pick the most efficient quantity and price if you are unwilling to accept the outcome.
Markets are great when all costs associated with a product or service is borne by the trading partners. But markets cease to function when third parties have to pay. Cigarette smoking is the classic example. Since we know that smoking creates costs that people other than the tobacco company or the smoker pay (for instance health care costs generated by second hand smoke), than we know that the “correct” price and quantity of cigarettes will be miscalculated by a free market.
Markets are great when all benefits associated with a product or service is enjoyed by the trading partners. But when third parties enjoy the outcome, markets also cease to function. For example, the more people around you are vaccinated against a disease, the less likely you will be to get it. Therefore, people who do not pay for a vaccination derive benefit from people who do. Under these conditions, the market is generating incorrect prices and quantities, since the cost of the product does not reflect the value being gained by third parties.
For profit business models aren’t perfect. Neither are nonprofits. I don’t think the solution to the world’s ills is for nonprofits to act more “business-like”, instead I see a future where the line between the for profit and nonprofit business model begins to break down. Where for profit business recognize that doing “social good” does not have to be at odds with profits. And where nonprofits recognize that doing “social good” does not mean ignoring the lessons of the business world.
I am an economics PhD student, and I just started thinking about this issue a couple days ago.
If the business model is totally self-contained and operates like a normal business and produces a normal profit, then chances are somebody is already doing it. Grocery stores make the world a better place, and make a profit at it.
So I set that category aside as “normal businesses” and instead focus on non-profits and “for-profits”. Where “for-profits” have the same non-market goals as non-profits but must achieve them in ways that also provide a return for investors.
To me, the only distinction between the two is how you raise capital. You bring in other issues like employee pay, but that seems irrelevant because both non-profits and for-profits can pay both high and low wages. The decision about where to raise capital should be (theoretically) independent from other decisions like how much to pay your employees.
So what is the real difference between the two? I split this into two conceptual groups: donor motivation and mission efficacy. Donors to non-profits don’t get a return, but they might think that more of their investment is going to the mission. Donors to “for-profits” are also losing money to some degree (if the venture returns a profit high enough to compensate for its riskiness, then it’s just a normal business, see above). They get some return back, but not as much as if the venture was completely focused on returns. Their money also partly goes to furthering the mission.
So what does it come down to? The result is shocking: Non-profits and For-profits are the *same*! In the end, all that matters is how efficiently investor/donor money is translated into mission results.
Think of it this way: both types are machines that convert dollars to mission results. Except for-profits just have an additional loop that converts dollars into, well, dollars back to donors.
What do you call a non-profit that gives back half of all its donations? A “for-profit”!
What do you call a for-profit that makes profits at a rate above market returns? A “normal business”!
Does this resolve the issue? Not entirely. The biggest problem is that you have normal businesses (as defined above) that also take in donations (e.g. Better World Books). Many of their donors do not realize that part of their donation is generating profits for investors. To me that is profoundly dishonest, like a beggar who makes enough money from begging to own a mansion and a BMW.
I hope this provides some new perspectives. I am interested to hear what somebody who deals with “social entrepreneurship” on a regular basis thinks of this theory as I am still in the process of developing it.
Adam, thanks for stopping by and leaving your thoughts. I think that mission focused and profit focused organizations are profoundly different, yet it is important to not make the assumption that a nonprofit structure means you are “doing good” and a for-profit structure means that you have a negative social impact.
Adam’s response illustrates the problem with academic training. He clearly has no experience operating in the complex world of nonprofits. His simplified distinction and reduction to who capitalizes what completely misses the different roles of customer and mission in these two arenas, and misses the actual returns in each area as well. A better approach would be for theoretically inclined academes (and those in training) to put their theorizing on hold, spend time in the actual field, and then form a theory.
Vince, I agree that the difference between for-profits and nonprofits is much more than their “business model” and their capitalization structure.
Why don’t you share with us your view of how the two organizational types differ?