How Nonprofit Economic Value Creates New Capital Sources
Read an excerpt from the book.
The Non Nonprofit: For-Profit Thinking for Nonprofit Success
256 pages, Jossey-Bass, 2012
The following is an excerpt from the book.
Calculating the Economic Value of Social Benefits
Quality nonprofits create benefits to society by addressing social problems, and virtually all the social benefits they create have monetary or economic value that can be identified and measured. A nonprofit that calculates this value can leverage its success into more effective fundraising, revenue generation, pay-for-performance relationships, and better ways of capitalizing growth.
An organization creates economic value when it increases revenue or eliminates costs, or both, for a stakeholder. These benefits typically accrue over time. The three components—increased revenue, decreased cost, and time—hold true whether the organization operates as a for-profit or a nonprofit.
Notice that the organization’s costs don’t enter into the equation. Costs and revenue are, of course, vitally important to the long-term health of any organization, but no one is going to pay any nonprofit for reducing its costs. You are (or you should be) paid for the value you create for others—through your outcomes, not your inputs or outputs. I emphasize this point because government and philanthropic funders typically evaluate nonprofits by focusing on their costs instead of the economic benefit or ROI they generate. More than once I’ve been asked why RISE! ’ s costs are higher than another program’s, even when our ROI is higher than that program’s.
Think of buying a car. As a consumer, do you care what it cost General Motors to build your vehicle? Or are you more focused on its value to you? General Motors cares about the cost because if its costs are higher than its revenue, the company isn’t profitable. GM also wants to know what the car is worth to you, its customer, because that value translates directly into the price it can charge you for the benefit of owning the car. As long as the benefit price is sufficiently higher than its cost, GM has enough margin to continue operating profitably. As the customer, however, you are concerned only with the price you pay for the value you receive.
Virtually every effective nonprofit creates economic value. However, there are some vitally important organizations—like art museums, zoos, and orchestras—where the economic value would be extraordinarily difficult, perhaps impossible, to establish. Of course, these organizations are essential to the community’s quality of life and have an intrinsic value. But they also create jobs and contribute to the economy in many ways. How do you determine the specific cash value they generate for state government or some other entity? In these cases, the economic value equation is not a useful tool for management. Management’s time and energy are better spent in pursuing other ways to build a financially stable organization.
However, every other nonprofit should be interested in establishing the economic value of its outcomes, because when its outcomes increase revenue or eliminate costs for a stakeholder, that economic value becomes a powerful tool.
Benefits that accrue in the future are worth money in the present. When someone gets and keeps a living-wage job, when an ex-felon stays out of jail, when an addict stays clean for a number of years, when a fragile senior is able to live independently rather than in a nursing home—all of these events have financial benefits now and in a foreseeable future. To accurately establish the economic value of programs that have outcomes like these, you must capture the value of these future benefits and compare them to their costs.
When you want to know what future cash flows are worth to you right now, the tool that is commonly used is net present value analysis (NPV). Economists, accountants, investors, and business analysts use it in capital budgeting to determine whether an investment is worth making financially. If the future cash inflows exceed the future cash outflows, discounted for the time in the future when they occur, the investment is considered financially sound. Discounting is a way of quantifying the time value of money (the idea that money available now is worth more than the same amount of money available in the future because it could be earning interest) and the risk or uncertainty of the anticipated future cash flows (which might be less than expected). 1
Another extremely important tool for determining the soundness of an investment or for comparing alternative investments is ROI. ROI is calculated by dividing the cost of the investment into the benefit or gain less the cost of the investment:
ROI = Gain−cost of investment/cost of investment
Business leaders use ROI and NPV to evaluate potential investments like developing a new product, acquiring a business, building a new plant, and purchasing new equipment. The social service sector should be using financial tools in the same ways for a number of reasons:
• Government can determine which programs provide the best social and economic return to society and therefore which ones it should invest in.
• Social investors and donors can identify those organizations that provide the best returns to society and use that information as part of their decision making.
• Nonprofit managers and boards of directors can make better decisions about how to spend limited resources. Nonprofits can use NPV analysis to assess the feasibility of investing in a new program or the economic soundness of an existing one and to convince stakeholders (including donors and government supporters) of the economic value that their programming generates in addition to its social value.
• Social entrepreneurs can be motivated to found organizations that serve populations who have greater barriers to success, like the generational poor. Certainly we should help people who have temporarily fallen on hard times, but those who live within chronic poverty generally cost the government more in subsidies and tax receipts over a longer period of time than those in situational poverty. Therefore, the high economic value of their maintaining living-wage jobs or using many fewer public subsidies is worthy of attention and remuneration.
Only when the social services sector addresses the specific economic value of social benefits can we become truly effective at addressing the huge social problems of our day.
Building Reliable Sources of Capital for Nonprofits and Social Enterprises
Once we start thinking about the social contribution that nonprofits and social enterprises make in terms of economic value, we can take an entirely fresh look at the size and scope of these organizations and how we finance them. Given what we’ve learned in the business world about the effectiveness of using large-scale, well-financed operations to attack large-scale problems, our current approach doesn’t make sense.
We have continuing, expensive social problems in the United States: poverty, teen pregnancy, the cost of incarcerating prisoners who reoffend, low-achieving schools, and the runaway costs of medical care, to name just a few. The need for solutions to these problems is high. Yet we are trying to meet that need with organizations that for the most part are small compared to the problems they tackle. There are hundreds of thousands of nonprofits with less than $5 million in revenue. Even the most successful nonprofits, like Goodwill Industries and Habitat for Humanity, have revenues the size of middle-sized businesses. A major factor is the lack of capital needed to scale up and sustain the organization at scale. Nonprofits understand this and are looking to do something about it. Many of the organizations profiled in this book, including College Summit, Playworks, and Common Ground, are engaged in major growth initiatives.
If these nonprofits were traditional for-profit businesses, they would obtain outside capital by selling stock or issuing long-term debt such as bonds. They would use this capital to build additional capacity, fund long-term research and development, expand to other markets, and make other long-range investments that would create social and economic value. But they aren’t for-profit businesses, and these traditional nonprofits typically receive funding from federal and state grants, supplemented by philanthropy. The organization is usually required to spend the funding in one to two years. As a result, nonprofits often have to make longer-term investments out of their annual expense budgets, or else they ramp up capital campaigns from time to time to seek philanthropic support.
Nonprofits don’t have the same access to long-term capital that for-profits do. Why not?
Social venture capital exists, of course. Some is invested in organizations to expand proven concepts; some is invested in start-ups. But there is virtually nothing available to sustain nonprofits at a scale commensurate with the need. That’s because there aren’t enough social investors with sufficient investment capital to make a difference. Social capital amounts to hundreds of millions of dollars spread thin across a dizzying array of projects, while market rate capital, typically focused on for-profit business, adds up to trillions of dollars.
Like for-profit businesses, nonprofits need a full array of sustainable vehicles that provide market rate capital to grow. So what to do? First, nonprofits must measure outcomes and establish the economic value of those outcomes. Then they need to turn to the same financial tools like NPV and ROI that for-profits use to attract capital for growth.
Multiple organizations are exploring ways to create sustainable funding for social purpose organizations. Three innovative programs (two of them in the pilot stage) that I’ll discuss are Lumni’s mutual-fund-like investment pools that fund higher education for low-income students in four countries; social impact bonds that are funding programs to reduce recidivism among prisoners in Great Britain; and the human capital performance bond to fund high-performing human service providers in Minnesota.
Reprinted by permission of the publisher, John Wiley & Sons, Inc., from The Non Nonprofit: For-Profit Thinking for Nonprofit Success by Steve Rothschild. Copyright (c) 2012 by John Wiley & Sons, Inc. All rights reserved.