Social change work is hard and frustrating and wonderful and terrible; it is also, at times, funny, quirky and just plain fascinating. With this blog we hope to capture all that goes into what we do at Capital Good Fund, and we invite you to join the conversation!

Thursday, September 18, 2014

Financing Nonprofit Growth, Part 3: Playing Catchup

This is part 3 of our series on Financing Nonprofit Growth.  Click here for part one and here for part two.

We left off our last post with Fun Finance struggling and Kite Drones taking off (pun intended).  Let's now take a look at where they are five years later.

Despite the odds, Fun Finance has perservered.  Though they only raised $30,000 in their first year, their revenues have increased year after year, reaching $390,000 in 2013.  They have maintained a 93% repayment on their loan portfolio; garnered national attention for the quality of their products and services; secured a US Treasury designation; built a robust network of community partners, funders, supporters and clients; and refined their business model to the point that they are ready to scale--exponentially, in fact.

So what's Fun Finance, a nonprofit, to do?  After running the numbers, they realize that they need at least $1.5 million in funding for operations for the first year of their scaling plan, as well as an additional $500,000 in funds for lending.  Bob's first instinct is to raise the $2 million through traditional philanthropy, though he quickly realizes the infeasibility of this approach: since their founding, Fun Finance has only raised $1.6 million.  The chances of raising more than that in a reasonable time frame seem infinitesimal.

Bob does know that he can count on a certain amount of philanthropic dollars, however, so he assumes $500,000 of the $2 mil will be donated.  But what about the rest?  Remember, Bob can't give away equity; he can, however, borrow money.  In fact, over the past five years, Fun Finance has lent out $600,000 to low-income families, and every dollar of that has come from money that the organization borrowed from individuals and institutions; in other words, Fun Finance has a track record of taking on debt, deploying it responsibly, and then paying it back.

This puts Bob in a position similar to that of Joe back when Kite Drones was just getting started: he needs a certain amount of money--$1.5 million--and he is going to try to find investors.  Sure, the investors are making unsecured loans to Fun Finance, as opposed to equity investments, but they are still expecting a return, the very opposite of philanthropy.  Bob is delighted: rather than begging people to give away their money, he is approaching them for an investment that will provide a return--a below market rate return, but still, 0-5% on a social investment ain't bad!

Bob has an additional advantage over Joe, namely that Fun Finance is not a start up, but rather a well-established, well run entity with a history of success and impact. In theory, a loan to Fun Finance should be relatively low-risk, and if a mainstream financial institution makes that loan, in addition to earning interest, it will also get Community Reinvestment Act (CRA) credit (click here for an overview of how CRA works).

First, though, Bob's Board of Directors will have to approve the plan, and this is where things start to get tricky.  You see, there is a long history of nonprofit lenders borrowing money for their loan pools.  And if you think about it, that's how most lending works: when you make a deposit at the bank or credit union, for instance, you are in effect making a loan to the financial institution, which then uses the funds to make loans to other individuals and businesses.  Lending to a loan pool makes a lot of sense and is relatively low-risk.  Why?  Because, though the loan becomes a liability on the organization's balance sheet (in the next post we're going to look more closely at balance sheets), it simultaneously becomes an asset; if the portfolio is strong, the asset will be worth more than the liability.  A strong balance sheet and loan portfolio mean that an organization is better positioned, and more likely, to pay back an investor when an investment comes due, just as a homeowner that owes less on the mortgage than the home is worth is better able to withstand economic hardship without losing the home.

Lending to pay for operating costs is another story, and there are far fewer examples of this among nonprofits.  Why?  Consider again that balance sheet.  This time, the money Fun Finance borrowers becomes a liability, but not an asset; the funds are spent on data systems, marketing and personnel, all of which will enable Fun Finance to reach more people and earn more money in the future, but these are not assets.  As a result, Fun Finance's balance sheet is now "upside down" (they have negative net assets--again, we'll cover this more in-depth in the next post), something that scares away many investors.

You can now see why the Board of Directors is reluctant, and you can also see a crucial difference between for and nonprofits: when Kite Drone takes on investment, it is selling equity, and equity does not weigh down the balance sheet with liabilities.  Therefore, if and when Kite Drone wants to borrow money (say to manage cash flow or purchase a new building), its balance sheet looks strong and healthy.  But because Fun Finance can't do the same, any financing it takes on, unless it's to buy a tangible good (building, vehicle, printer) or to make a loan, weakens its balance sheet.

For any social entrepreneur there inevitably comes a time when they wonder whether going from tax-exempt to for profit, or the other way around, makes sense.  Here's my take on it: the only advantage of a for profit is the ability to take equity, which can be a huge advantage.  Otherwise, the nonprofit doesn't have to pay taxes, is subject to less regulation, can take donations, and can borrow money.  For the vast majority of instances, the choice seems clear (this all assumes that the entity has a charitable can't just create a nonprofit to do anything you want, and the IRS has to approve the tax-exempt status).  But when it comes to financing nonprofit growth, things get a little murkier.  If the proportion of assets to liabilities becomes a major barrier to borrowing for growth, then the inability to take equity has the potential to stop growth in its tracks.

Think of it this way: Fun Finance has been playing catchup with Kite Drone since day one.  Not only are they trying to run a business, but Fun Finance is also doing so with the added challenge of solving seemingly intractable social problems!  This is why I think Bob's job is harder than Joe's, and it's why nonprofits ought to be allowed to take more risk as they look to scale; after all, what better risk is there than one predicated on the possibility of making things better?

In the next post we're going to look more in-depth at the balance sheet of Fun Finance as they ask the Board for approval to take on debt.  We'll then discuss options for making the plan more palatable!

Comments, as always, are welcome!

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