My newest column in the Chronicle of Philanthropy appears below. You can find an archive of past columns here.
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.
I’m a social worker, not an accountant, so some of this was new thinking for me, but it’s a critical point, and raises really the flip side of your earlier discussion of high impact v. high performing nonprofits–there are those NPOs that are high impact but barefly hanging on–achieving their outcomes because of tremendous staff effort or a convergence of fortuitous factors, or whatever…but they quickly burn out because of inadequate capitalization to really take their models ‘to scale’. In the long run, that won’t get us to our goal any more than investing in high performing organizations that, while efficient, fail to have significant impact on their targeted problems. I’m glad that you continue to raise these issues, especially given the rise of the Social Innovation Fund and the need to seize that opportunity.
Thanks Melinda. You got what I was shooting at. Glad it wasn’t too jargon-y! Making nonprofit accounting interesting is a bit of a challenge!
Our philanthropic entity ain’t got no home and we can’t win for losin’ in the world of accounting.
Wings for kids, a 12-year old non-profit organization, is going through a rigorous and costly effort to prepare to scale up our program that has shown great promise in closing the achievement gap.
Here’s our annual dilemma. Right now, we report expenses in two buckets: the “program expense” bucket and the dreaded “management and fundraising” bucket. Because there is no such thing as an “equity” bucket (according to Financial Accounting Standards) – each year we have to decide:
1. Do we put our “equity” expenses in our program expense bucket – which makes our service delivery per person cost appear too high. ?
2. Or do we put these capacity building expenses under “management and fundraising” which makes our dreaded “management and fundraising expense percentage” too high?
Either way, we lose with people saying, “Wow, Wings has such an amazing impact on kids – I just wish you didn’t spend so much money.” Then the follow up comment is either: “your cost per participant is just too high” or “your management and fundraising expense is way out of line!”
Our Board chair says, “We have to hope that those in a position of leadership in philanthropy will lead and make the changes that are so obviously needed!” (She’ll be happy to read your column.) “And, in the meantime, we have to find the courage to do what we need to do and find sophisticated philanthropic investors to invest.
Well said, Sean. I think the biggest challenge relates to your closing point concerning the adoption of this kind of accounting. The methods of equity accounting are well established and not difficult for trained professionals to apply. Rather than a regulatory approach, though, I think we need economic incentives to untangle the chicken-and-egg problem that nonprofits won’t adopt equity accounting until they know it will attract equity funding, and funders won’t provide equity-like grants until they know that nonprofits can manage the money, i.e., they practice equity-accounting. Just as funders need to provide capacity-building grants if they want high-performing nonprofits to become high-impact organizations, they must also offer to fund more sophisticated financial management practices if they want to scale what works.
Thanks, Sean, for an excellent continuation of the conversation about supporting high performing organizations – and by extension – programs that make a difference. Accounting is not my field, but I certainly am familiar with how nonprofits tend to be starved for philanthropic equity. Thanks for highlighting this critical aspect of the conversation about performance.
Ginny thanks for highlighting a compelling example of the need for philanthropic equity accounting. I just tweeted your comment and added it to my Daily Digest post.
Steve, I’m with you, but think we need official recognition to get things moving. I don’t see this as new “regulation”, it is just an accounting change. Maybe FASB can trial it with a small set of organizations?
Great piece, Sean!
Thanks for continuing to champion the concepts of Philanthropic Equity, a term that hardly existed just a few years ago. Thanks, too, for highlighting the work we are doing at NFF.
Our efforts complement the work of many others who are also pioneering new techniques for capitalizing the growth of high performing nonprofits. All told, I have tallied up more than $300 million worth of grants made in recent years that can legitimately be called “equity-like”.
As Steve points out, we don’t know yet exactly which of the various techniques will function best, and thus, exactly which should be encoded into a shared standard of accounting.
But with all of these exciting experiments underway, I feel confident that now is the time to begin the process of coalescing around what we, as a field, are learning.
One thing feels for sure. The sooner we can establish (and then evolve) shared standards, the sooner a broad and healthy market for philanthropic equity will come into being.
Thanks for the great post Sean. I forwarded it on to my CEO and our President of the board.
I hope we continue to move towards the shared standards and I have high hopes we will. Remember that as recently as the 80s & 90s everyone was focused on program replication as a means of expanding social impact. Then, towards the beginning of this decade, we shifted focus to building organizational capacity. We, the nonprofit and business world, thought this might be the best way to deliver effective programs. However it became evident that too few funders and donors pay attention to building solid organization foundations.
Philanthropic Equity is the way forward.
Sean, I take your earlier point about involving FASB as a way of recognizing the whole idea of equity capital. As George pointed out above, this is still a relatively new concept that isn’t yet widely understood. FASB recognition — and the public comment process that would precede and inform it — could help get the word out on what it is and why it’s important, establish familiar concepts and terminology, and provide a common point of reference.
Steve, I’d guess you understand this topic better than I do. I know George does.
Thanks for the support. I hope you’re right!