The general framework of how money flows in the nonprofit sector is focused on the assumption that nonprofits need to chase donations. This is also how the business sector works; companies chase revenue.
But investing is different. Investors often are the ones chasing the best investment opportunities. It is simply an issue of supply and demand. While there are lots of companies and nonprofits who want to sell things to consumers or raise money from donors, there are a limited set of really good investment opportunities. This fact is frankly recognized in the financial markets where investors are constantly searching for great investment opportunities and then competing with other investors to secure a piece of the deal.
It seems to me that we are on the verge of an inflection point in philanthropy where the supply of philanthropic dollars is increasing just as it becomes more widely recognized that nonprofits are not all equal in their ability to achieve results and platforms are being developed to showcase the select group of nonprofits which offer potentially outstanding philanthropic investment opportunities.
If the social investing framework flips the direction of the “chase” from money to philanthropic opportunities, the landscape of philanthropy will look quite different. I first wrote about this concept in a 2008 Financial Times column where I discussed what philanthropy might look like in the year 2033. I suggested that “investment ready” nonprofits would likely list themselves on some sort of “exchange”:
The business of giving money away is particularly different for large private foundations and smaller “impact-oriented” foundations. Instead of expecting non-profits to solicit them for grants, these foundations’ “impact committees” and “program analysts” spend their days looking for and researching potential grantees. Given the considerable information disclosure required by the exchanges, much of the information required for grantee research is available online. Third-party evaluation firms provide regular reports on listed non-profits and these reports are a valuable input for the foundations.
While the cost to non-profits of conforming to the exchanges’ information disclosure requirements is steep, once listed they find grant dollars come looking for them rather than the other way round. Exchange-listed non-profits tend to have small fund-raising groups that focus on “donor relations”.
We can see some of these themes playing out at the Social Impact Exchange conference being held in New York this week.
In a recent post title “Money Chasing Ideas” Lucy Bernholz reflected on how many social entrepreneurs find it easier to raise for-profit funding than philanthropic capital:
“…the reason it was easier for the entrepreneurs to pitch VCs instead of foundations was simple – the commercial funders were there. They were at the meetings, mixing it up with entrepreneurs, inviting pitches, taking meetings on sidewalks, etc. The foundation executives – much harder to find.
This has nothing to do with social impact, social returns, or appropriate business models to produce social and financial returns. It has to do with who is out looking for ideas to support and who is waiting for the ideas to find them.”
There will always be a need for fundraisers to seek out donors to solicit donations from just as there will always be a need for sales people to find customers. There will also always be a need for unproven nonprofits to desperately seek growth capital funding just as early stage companies try to get in front of angel investors and venture capitalists.
But I think smart funders who want to invest in the growth of outstanding nonprofit organizations are going to need to restructure their process so that the thrust of their work revolves around proactively locating great philanthropic opportunities rather than passively wading through grant applications.
I am no expert on philanthropic theory, but I often feel like many of the blogs, including this one, about philanthropy are recycling or re-arriving at the same ideas, always painted as some new innovation. In reality, there’s nothing new under the sun. I don’t mind hearing the ideas so much as I find it slightly lacking in self awareness. The important thing, I think, is to recognize the ideas that most directly relate to human nature and reflect techniques which use that understanding in a positive way.
I think this post does that. It picks up on a key difference in how people value one another and how they work to enrich their lives. Do they collaborate or condescend? The different approaches solicit different reactions from those they interact with. By seeking after good ideas, bright people, and strong skill sets you are more likely to find untapped potential and encourage success through spontaneity. When you wait for others to humble themselves and come, you encourage groveling and dishonesty in relationships characterized by boundaries, limitations, and a sort of inequality. Philanthropy ought to reflect a combination of humanistic altruism and genuine work ethic. Thanks for the post!
I’m glad you liked this post!
Sean, thanks for the insightful post. I can vouch for the sense of a looming inflection point in philanthropy. The conference, which is concluding as I type, has brought out some great comments and thoughts. The key to me is whether or not the energy displayed over the past two days will carry forward beyond the conference. If it doesn’t, the philanthropic community will have let another great opportunity to pass it by. My hope is that the conversation does continue and the we can speed up the actual transformation.
While trying to avoid sounding like too much of a downer, I would suggest that we generally overestimate the amount of change that can be achieved in the short term and underestimate the amount of change that is possible in the long term. I’d be surprised if big dramatic change comes out of the conference, but it is one more towards significant and lasting change.
Sean, undoubtedly you will be correct. Such a change will require more than a conference and its follow-up. That said, I remain every hopeful and optimistic. 🙂
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Sean, I agree with what you say about money chasing investments.
I carry around a newspaper article that describes how several venture capital syndicates competed against each other to invest in a promising alternative energy company. These were entire syndicates, not just individual investors, who offered to fill the entire round, not just a portion, of required equity.
The Kleiner Perkins syndicate won because they were able to offer up Al Gore as a board member. Each of the syndicates had money, but Kleiner had something else, too, that would help raise the probability of building a successful company. And that is why they won.
This is a clear example of investors’ money chasing a hot investment opportunity. We need to remember, though, that the company will nevertheless need to chase revenue money for the rest of its days (from its customers).
As a rule, the money does the chasing in capital markets, whereas the companies do the chasing in the the revenue markets.
Its because equity is a scarce one-time investment opportunity (money in exchange for building the successful organization) whereas revenue is an abundant ongoing thing (money in exchange for program execution).
With equity, you are playing a game of musical chairs. Who gets a seat? With revenue, there’s always room for more.
This is a main reason that NFF Capital’s 16 clients have been able raise $320 million of unrestricted growth capital (Philanthropic Equity) over the last four or five years.
Another dynamic is that the philanthropic equity funders are beginning to realize that the success of their investment depends upon how much focus they can provide for the management team they have backed. For this reason, if another equity investor shows up that is disruptive for some reason (perhaps imposing an incompatible theory of change), the first investor may decide to write a bigger check thereby “cleaning up the balance sheet”, as it is sometimes said.
That is one reason why entire syndicates compete against each other, and the funder becomes (for equity) actually ends up leading the fundraising effort. For very good reasons, this happens all the time in venture capital, and I am beginning to see it happen with philanthropic equity as well.
We may be evolving towards a nonprofit system where the most promising nonprofit business plans get relatively turnkey financing for their equity needs.
Thanks George. A for-profit won’t take any and all investments because they have to give up equity to get it. Why would a dynamic arise where funders would be forced to compete? Under what situations would a nonprofit decide to limit the amount of growth capital they were willing to accept?
A GREAT question, Sean. It is so obvious why for-profit investors are willing to fight over a deal: the winner gets to keep the profits. So why would nonprofit investors fight over a round of philanthropic equity? And why would a nonprofit ever say no to more equity?
Emphatically, I will say that I believe these scarcity-of-equity behaviors have already begun to emerge. I see them in my work. At the same time, I wish I could say that the reasons for these behaviors are easy to explain.
Reason #1: Metric of Success Depends on How Much Equity is Consumed
Investors of philanthropic equity don’t get their money back, but they DO care about what is accomplished by their investment. And fundamentally, their investment is intended to build a “mission factory” that others may (or may not!) use to turn their own money into effective program execution.
Here’s how an equity investor thinks: “I love this program! And I could use my money simply to pay for next year’s execution, but instead I will use my money as equity: to help build an organization that is so COMPELLING that OTHER people will decide to pay for the program I like, year in and year out.”
“My metric of success is two-fold: How much does it cost to build the factory? (I want this to be a low number, and will insist that it not be watered down unnecessarily.) And… how much, through the course of time, will other people use the factory ? (These other people provide revenue, not equity.) ”
“I will NOT enter into this risky investment if it looks like more and more money will be raised in the name of equity, because that will mean that my return on investment is low. On the other hand, if the total amount of equity raised looks small compared to the amount, over time, of other people’s money that goes towards the program I like, then I certainly WILL make the investment.”
Reason #2: Wisdom of Weaning
Suppose I am a social entrepreneur who intends to replicate not just my program nationally, but also a way of paying for that scaled-up program. (This duality of program scaling/business model scaling MUST be present: the alternative would be bankruptcy.) If I am brutally honest with myself, I realize that conducting a capital campaign for equity growth capital is NEITHER SCALABLE NOR REPEATABLE. Unlike other ways of attracting funds, I can’t grow my campaign ten-fold three years from now. Nor can I keep coming back with growth capital asks, if the growth hasn’t happened. Moreover, every time I accept more equity money from my national office campaign, it REDUCES PRESSURE to develop the decentralized fundraising skills we will need to sustain our growth. Indeed, the only way to keep pressure on building the scalable and repeatable business model is to clearly include the WEANING from equity into our case statement. I recognize the wisdom of LIMITING the amount of equity I take on, because that will accelerate our pace of learning how to attract revenues in a way that is scalable and repeatable. My investors understand this too, and because they want to avoid dependency relationships, they will not agree to write a big check unless weaning is a clear part of the plan.
#3 Wisdom of Capital Aggregation.
When I asked a social entrepreneur what his theory of change was, he quipped: “I don’t know. Who is the last funder I met with?” We went on to describe himself as being in the “chameleon business.”
THIS HUGE PROBLEM EXPLAINS WHY SO FEW NONPROFITS CAN FOCUS ENOUGH TO REACH THEIR GOALS.
And indeed, the biggest benefit of the philanthropic equity concept is that, by designating who IS and who is NOT a formal source of equity, and by then insisting that the equity investors all sign up for the SAME PLAN, which includes a single theory of change and a single way of reporting progress, we bring focus to management that has been so sorely lacking.
Investors are beginning to understand this. Their thought process: “The more focused we can make this management team, the more likely they are to GROW and WEAN, and thus the more likely our investment will be a success. Therefore, as investors, it is in our interest to limit the number of influential equity investors who are invited to participate. If required, as a way to focus down the number of equity investors, we may even write a bigger check. thereby filling out the round ourselves rather than leaving room for other funders who may be less aligned with the organization’s strategy and bring distraction.”
The organization’s management team and board feel the same way: “We have worked hard to develop a winning strategy, which calls for a certain amount of equity, after which program execution will be sustained by something other than an equity capital campaign. Our best chance of success is to build maximum alignment among our equity investors, and… once the equity is raised… to focus keenly on developing NON-equity ways of sustaining our growth. For this reason, we will declare a clear end date to the equity campaign.”
#4 Pseudo Naming Rights
think of a capital campaign to build a building. Funders often compete to see who gets the naming rights for the building. This is possible because a building is a permanent thing with a known price tag. We can answer the question: “Who paid for that permanent thing that continues to be so highly valued?”
Well, philanthropic equity is similar: the “building” is a permanent mission factory (sustained by folks who use the factory to turn their money into effective program execution) and the price tag is the amount of equity that was consumed before the long-term sustainability model fully kicked in. With rigorous accounting as to who IS and who is NOT an equity investor, it is possible to answer the question: “Which funder was most responsible for giving rise to this valued nonprofit organization?”
I will stop here. I suspect this is MUCH MORE than you were looking for, and wish my answer were simpler. Perhaps, over time, we can collectively come up with a cleaner articulation!
I for one, am glad you did not stop earlier! I think your response to Sean’s question is terrific (and probably could be expanded by you into an important monograph).
I wonder whether increased equity-like funding will increase “investor” oversight, including demand for board seats (voting rights). If this is thought to be the case, a similar case to for-profits can be seen, where the social enterprise limits capital in order to limit changes in board composition which could affect future direction.
Sean, I would be interested in your (or other’s insights) into how often and in what shape these type investments lead to board composition changes as part of the deal structure.
I’m going to reply more fully in a blog post. However, Kevin, it is interesting to note that in the social sector funders getting a board seat is often viewed as a conflict of interest issue (because now they represent both sides of the fundraising table). But I think the concept can certainly make sense for Growth Capital funders.
Thanks for your comments, Kevin and Sean.
I forgot, and should have included investor “rights and privileges” on my list of reasons investors of philanthropic equity might be willing to compete. It isn’t happening yet, but board seats, right of first refusal on future rounds of equity, anti-dilution rights, blocking rights on future rounds of equity, certain strategic veto rights, rights to select management, and all sorts of other control provisions could be conceived of what an investors receives as part of the “deal”, and what a nonprofit board might be happy to provide for a particularly attractive investor.
As a field, though, we aren’t yet ready to try these out, and they certainly are not a part of NFF’s standard practice. My view is that while I see potential merit in some of these arrangements, I also see possible pitfalls, and so we council clients to tread very carefully.
There are good reasons why, currently, finders generally do not take board seats as a quid quo pro for their investments. These are the same reasons why, generally, large customers of a for-profit company are not offered board seats: (a) with multiple customers, it would be impractical to have so many in the board room, and (b) there is often a conflict of interest between customers (who want to “exploit” the firm as much as they can in the name of a good deal) and the company (which needs to say “no” sometimes, if a customer is asking for things, like ultra-low overheads, that are long-term damaging to the company’s health). Often, the board, in its role as long-term steward to the the nonprofit, is the body that needs to say “no” to and push back against unhealthy funding propositions. It follows that the funders who approach the nonprofit with those propositions, is best excluded from the board room. Conversely, funders who seek accountability would find it uncomfortable to sit on “both sides of the table”.
The story is different for investors of philanthropic equity, though. Unlike other funders, these check-writers are all about the long-term, and, like the board, they are all about managing through strategic changes. Indeed, I would go so far as to say that funders of philanthopic equity do a disservice if/when they set up their own non-board processes for managing their investments. Much better is for them to affect mission and strategy as an integral part of the existing governance structure. Otherwise there are TWO governance bodies, and that makes life difficult.
I am therefore a fan of integrating philanthropic equity stewardship into the board process. Indeed, more and more investors of philanthropic equity (like New Profit) take board seats as a matter of course.
Nevertheless, in our capital campaign work, (so far, anyway), we have left board representation out as one of the standard “deal points” for an investment of philanthropic equity. This is because we do not yet have proper syndicated structures. In the future, once the art of setting up proper syndicates (through investor agreements) has been evolved, I expect that one or two board reps for a syndicate will be typical. Right now, though, the arrangement for most rounds of philanthropic equity investment resembles what is done with other capital campaigns (buildings and endowments): each check involves a separate contract with the nonprofit. With so many separate one-to-one relationships, it would be unwieldy to decide who does versus who does not get a board seat. Eventually, with a true syndication methodology, the investor’s agreement can be used to decides how the group of investors will be represented.
I hope that’s not too confusing! And yes, perhaps this would best be communicated in the form of a carefully written monograph! thanks for bearing with me!