By Fred Leeb, originally published in Huffington Post on September 12, 2012
Who is Responsible to Ensure that Nonprofits Operate Most Efficiently?
Everyone and no one. While the great majority of people in the nonprofit world are good people, this doesn’t necessarily mean that the financial system is functioning most effectively. When everyone and no one is responsible, it means that nonprofit clients/customers/patients can easily fall through the cracks because nobody without other vested interests represents them at the table. This is a tremendous flaw in our nonprofit system. The most vulnerable people often have:
- No voice of their own in the process,
- No leverage,
- No significant buying power,
- No vote,
- No seat on the board,
- No direct communication links to decision-makers,
- No ability to take their business elsewhere, and
- No substantial access to outside professional help
While there are many stakeholders, auditors, reporting requirements and accreditation organizations, there are no organizations or individuals who are tasked to disrupt the status quo to create positive change. Many different stakeholders could do so but it is much easier and much less risky to just continue business as usual.
Why Would Mergers Be an Effective Strategy?
In my prior article, “Nonprofits are Now Too Critical to Fail,” I noted that, 46.2 million people were in poverty in 2010 according to the U.S. Census Bureau. Of those, 15.7 million were children under 18. Under today’s high-stress, budget-cutting conditions, it is all the more important that nonprofits use each dollar they receive to the maximum by operating most efficiently. But the great majority of nonprofits are very small. Approximately 83 percent (or 304,000) of the registered public charities that filed a tax form had revenue of less than $1 million in 2009, according to the National Center for Charitable Statistics (NCCS). But these small nonprofits had a total of about $60 billion in revenue. One way for these small organizations to operate much more efficiently for the benefit of their constituencies is through mergers, but mergers have been very rare even though they already have swept through the corporate community. This article explains why there often appears to be no sense of urgency amongst nonprofits to accelerate the needed changes to increase efficiency.
Does the nonprofit system incorporate an adequate self-policing mechanism?
For-profit corporations are far from perfect, but they have many more checks and balances to cause them to operate efficiently. The top 12 reasons why nonprofits do not have an adequate self-policing mechanism are as follows:
- Board checks and balances: Many of the corporate counterbalances to the CEO do not exist. There are no major stockholders who have their own vested interest in the organization. Many nonprofit board members serve to assist in fundraising and to contribute to the community rather than oversee the CEO or ensure efficient operations. In addition, many board members have been selected because they are friends or family members of the CEO, making it very difficult for them to be objective in decision-making.
- Stockholders: Nonprofits do not have voting stockholders and therefore are not motivated by the need to increase shareholder value or dividends.
- Operational reporting: The measures of success for a nonprofit are often relatively fuzzy in comparison to a for-profit, which is measured by net income and cash flow. Financials are not paramount. Success is more likely to be measured in outcomes, which may be more qualitative than quantitative, rather than in financial statistics. For example, a soup kitchen generates no revenue or profit from providing its services but is still vitally important to the community. This lack of clarity, however, makes it much more difficult for board members and funding sources to determine whether the nonprofit organization is operating most efficiently.
- Executive compensation incentives for change: It is much more difficult to include incentives as a major part of a nonprofit CEO’s compensation. Nonprofits cannot generate increases in their stock price. There often is no mandate to generate surpluses and measures of return on assets or equity are not applicable. Also, CEO’s may have more downside risk than upside opportunity in a merger or acquisition. They may lose their own job if the other CEO takes over and they may find it difficult to measure success even if the merger works as planned. There also is no golden parachute if they leave, as there often is in a for-profit merger.
- Grant sources: Grant sources have a substantial amount of leverage and resources but they generally do not use these capabilities to require far-reaching and fundamental changes such as mergers and acquisitions. Their leverage is because they are highly sought after as one of the very few sources of cash that can be used for growth or capacity-building, since their funding may not be restricted to a specific program. The grantors, however, generally believe that getting into the day-to-day management of a grantee is beyond their scope and capability. It also leads to controversy and confrontation that is uncomfortable. Grantors also have not traditionally recommended or required that the grantee hire a consultant to provide new ideas or be an agent for change, as virtually all banks do with their troubled corporate customers. Grantors are commonly set up to do their due diligence prior to approving their grant and in auditing their grantees to see that their funding is being used in accord with the grant.
- Fee-paying customers vs. nonprofit clients: Nonprofit clients often have no financial leverage or voice to demand better goods or services and push for change. Many clients, particularly of human service organizations, have no assets, minimal or no income, no access to the media and no relationships with influential individuals or organizations. They also often cannot go elsewhere to obtain their goods or services and are subject to virtual local nonprofit monopolies. There frequently is almost no first-hand relationship between the clients and the board members, funding sources or even executive staff members.
- Banking relationships: Banks are much less proactive with their nonprofit customers. Banks are reluctant to become involved with nonprofits in the first place and often have difficulty working with nonprofit financials. Banks are torn between considering a loan to a nonprofit as a business relationship and the bank’s own effort to give back to the community. Banks do not want to turn their charitable efforts into a negative public relations situation where they are considered the evil overbearing financial institution squeezing a helpless nonprofit by threatening foreclosure to obtain its debt service or repayment. Once a loan is made, banks generally will try to maintain a low profile rather than push for change as they would with a corporation. For example, if chronic and severe financial problems arise with a corporation, banks will immediately shift the customer to their workout departments to push hard for improvements. They also may require the customer to operate under a highly restrictive forbearance agreement and hire an experienced turnaround consultant as a change agent.
- Outside professionals: Nonprofits have a relatively limited relationship with their outside professionals due to very tight budgets. Nonprofits frequently try to hold spending on outside professionals to an absolute minimum (due to their grantors’ strict mandates to hold down administrative costs) and will often try to use professionals (whether or not they are on the board) on a pro bono or a reduced-fee basis. Professionals will only contribute their services to a limited extent on this basis.
- Auditors: Outside auditors generally will not go beyond their well-defined scope of work. Their scope generally does not include pushing management to make major specific operational changes. The auditor’s objective is to obtain reasonable assurance about whether the financial statements are free of material misstatement. Auditors may, on relatively rare occasions, provide a “going concern” disclosure due to recurring losses or other factors raising substantial doubt about the organization’s ability to continue as a going concern.
- Accreditation organizations: Many organizations exist to accredit various types of nonprofits but the value of this work is dependent on whether it is actually used by the CEO and the board. Accreditation reviews often are years apart and are viewed by outsiders as a stamp of approval. It is relatively rare for stakeholders to get into what is often voluminous detail on the organization that was reviewed.
- Internal financial constraints: Nonprofits must keep staff costs to an absolute minimum. They generally operate on extremely small gross margins because funding sources often allow only 10-15 percent of their grants to cover all the administrative costs of their programs. Nonprofits generally have no cash for growth, reinvestment, training or investigation of a potential merger to increase efficiency. Sometimes the larger nonprofits are able to conduct major capital campaigns but these are generally either to build an endowment or construct a much-needed building. Frequently, the cash in an endowment can be accessed up to a very limited amount per year (often five percent) to prevent the endowment from being depleted rapidly. Nonprofits also have difficulty obtaining a credit line to help even in normal seasonal fluctuations because it is difficult for banks to deal with their receivables as collateral.
- Information constraints: Information on other nonprofits as potential merger candidates is difficult to obtain. Nonprofits report annually through their 990 tax returns but these are often available long after the reporting year is over. In addition, there is no tradition of using investment bankers or business brokers to identify, recommend and facilitate nonprofit mergers and acquisitions (due to a lack of financial incentives). This frequently leaves the organization reliant on the CEO to initiate merger and acquisition efforts, though the CEO’s job security may be at stake if he does so.
Based on the 12 points listed above, everyone and no one is responsible for nonprofit finances and nonprofits do not have an adequate self-policing mechanism to ensure that they will operate most efficiently. Though the vast majority in the nonprofit world are working very hard and are very good and honest people, the issues listed above represent a tremendous problem enabling the waste of many millions of dollars every year. It is sad that the biggest losers are the most vulnerable who have the least capability to have their voices heard and push for change. Even though there are many instances where the checks and balances that are present in the corporate world have not been adequate, they are still much stronger than those that exist in the nonprofit world.
My opinion is that foundations are the logical candidates to fill the void and take on the responsibility of pushing nonprofits to operate with much greater efficiency and professionalism in the future.