Paradox of nonprofit investment pits mission against rates of return

Published in the May 23, 2008 edition of Columbus Business First

Nonprofits exist because their mission is to provide a service that has no profit potential.  But with donor dollars more difficult to find, they are moving to more profitable activities. 

This is a wise choice strategically but it creates a new problem:  How does one decide where to invest?  In profitable but low-mission activities, or unprofitable but high-mission activities?

For-profit companies do not face this dilemma.  They will only make investments that promise to make money. 

Recently I attended a finance committee meeting of one of my nonprofit clients and we were debating whether to go ahead with a project that would require about six years for the nonprofit to recover its money.  At this point, a new board member with extensive financial expertise in the for-profit sector said:

“That’s a 17 percent return, and in my business we would jump at the opportunity.” 

Hearing that, I knew it was time to write about the paradox of nonprofit capital investment and how decision-making based on return on investment can starve a nonprofit’s highest mission-related activities. 

Nonprofit capital scarce

A critical factor in evaluating an investment is how much an organization must invest of its own money. 

Most nonprofits hold the bulk of their nonphysical assets in restricted form, which means management has no discretion in how the money is used.  As a result, the few assets that are under management’s control are particularly valuable as a cushion for operations. 

In other words, an unrestricted dollar today is more valuable than a future dollar resulting from an investment.  This reality sets a high bar – technically a high discount rate or internal rate of return – for a potential investment to overcome. 

This bar is much higher than most for-profit companies would set for their investments. Moreover, a for-profit business can seek bank financing.  Unfortunately for most nonprofits, a lack of unrestricted assets renders them often unqualified for bank financing.

Most nonprofits have capital fundraising campaigns and wait until the money is raised before investing in their business.  This approach means nonprofit capital projects need to have much higher unleveraged rates of return. 

It is rare to have a capital campaign more than once every five years.  Imagine a for-profit company trying to thrive if it were hamstrung with either limitation in its investment program.

High returns, low on mission

Limiting investments to only grand slams may not seem so bad.  Unfortunately, high returns collide with the non-profit’s goal to place emphasis on providing services that cannot be provided by the for-profit sector.

The label “nonprofit” is literally true for the highest mission activities.  Investment in high mission will not create profit and will not show compelling returns. 

On the other hand, nonprofits have low-mission activities precisely so they can earn profit that can be used to support unprofitable, high-mission activities. 

Let’s reconsider that board member’s suggestion that 17 percent is a good standard for worthwhile investments.  This return is higher than any high-mission investment can produce.  At the same time, because nonprofit capital is so scarce, it is far too low a return to demand from low-mission activities, which justify diverting capital away from high-mission activities only when they are highly profitable. 

So perhaps 17 percent is never the right number.  If the project is being done to earn a profit, maybe that scarce capital should require a 33 percent return so the investment dollars can be recaptured quickly to use for higher-mission needs.  A 33 percent return is likely possible only if the nonprofit puts a very small amount of its own capital into the project and seeks outside donors or lenders, who will likely insist on profit-making investments. 

Investment paradox

Nonprofits have an incentive to seek outside funding for investments in the lowest-mission activities where they can better leverage their scarce capital.  Similarly, outside funders want the greatest return for their investments or donations, which is most easily found in low-mission, but profitable activities. 

And there lies the paradox:  The most important areas to invest in are the low-return, high mission activities. 

We need a new approach to measuring the value of nonprofit investments.  It needs to solve the paradox that conventional financial measures steer outside capital away from high mission investments.  If we don’t, then we will be pushing our nonprofits away from mission and into the for-profit world.

Allen J. Proctor was formerly chief financial officer of Harvard University and is the author of Linking Mission to Money(R) Finance for Nonprofit Board Members. Subscribe to his free newsletter at www.proctorconsulting.org.

Copyright 2008. Reprinted with permission, Business First of Columbus Inc.