We Need a New Business Model for Nonprofit Charities

By | May 10, 2016

Hollywood 001In my tenure as the leader of a community based organization in Southern California, I have seen dozens of small agencies go out of business. Some of these charities performed amazing services for the most needy people in our society. They provided shelter for people living on the streets, counselling for women fleeing abuse, food for the hungry, and support for people lost. They were supposed to be easy causes to raise money for.

One by one, however, these heart-felt, mission-driven nonprofit organizations shut their doors for good. No more food, no more beds, no more counselling.

Why couldn’t they stay in business? Because the business model for operating nonprofit charities is broken.

It used to be that generous people would write checks to their favorite charity. They didn’t have to examine the organization’s 990 tax return, or go onto a charity-tracking website to find out how much money was spent on overhead. They gave because they believed in the mission of the nonprofit group.

Then, some charities took advantage of donors’ trust. They spent donated money unwisely, or embezzled money for personal use.

Rightfully so, donors responded by being more savvy. They decided that charities should only be able to spend on a small amount of overhead. And if that amount got too high (say 15% or 20%), donations dried up.

Today, the success of charities is typically ranked based on how much the group spends on overhead, not on the quality of services or programs. But is evaluating a group’s overhead rate really a good assessment tool?

In my experience, if charities continue to be judged by overhead costs, more will go out of business.

Just imagine being on the Board of Directors of a $1 million per year nonprofit organization. If today’s overhead-perspective guided your charity, then the amount of money that can be spent on overhead would be $100,000 to $150,000 per year (10%-15%).

This overhead budget would have to include the salary of the Executive Director, Finance Director, maybe a Fundraising Development Director, support staff, and the typical administrative costs to keep a building open—rent, electricity, telephone, travel, paper, pencils, and any fundraising costs, like mailings or events.

Such a budget does not add up to $150,000. Unless, as a Board member, you hire Directors who are really low-paid program managers with no expertise in actually running and selling a charity. And, this is why many nonprofits go out of business.

You get what you pay for. Low overhead means low compensation to the staff leaders. Low compensation means low quality leaders who know how to help a person but not run a financially stable organization.

So what type of business model will sustain a charity system that depends on public and private funding? Here are two main ways to keep nonprofits in business:

Understand and Fund All The Costs of Charities, Not Just Programs.

In today’s overhead-perspective, funders like to give their money specifically to programs. They feel better that their money is going directly to “help people”. But if government, foundations, and private donors do not pay for all of the real costs of running a nonprofit group, then that organization will close, and no longer able to provide services.

Someone, or some funding entity, needs to pay for overhead costs. And not only these costs, but also future operational costs. Like, a “rainy day” fund when private donations are below expectations. Or, a deferred maintenance fund, for replacing the roof, the carpet, out-of-date phone or computer system.

For the past decade, one of the many programs at the agency I lead, was a large homeless shelter in Los Angeles. It cost us more than $1 million per year to operate. Only half of that money was paid for by government entities that convinced us in the first place to open up a much needed program for people who were homeless in their neighborhood.

Ten years later, with a total of $5 million investment of our own private funds in this program, as well as the need for $500,000 of deferred maintenance (new kitchen, new bathrooms, new flooring, new plumbing – basically a new overhaul of the facility), we plan to shut down this program.

Funders were willing to pay for the program, but not all of the costs to operate that program. In the long run, only funding programs, but not their operating costs, will result in programs shutting down.

Assess Charities By The Quality of Their Programs and their Results

If you are going to analyze a charity, examine how they run programs, not on how little they spend on overhead costs.

With many of the government contracts we operate, we spend more time with audits on how we spend the money than on whether we have truly helped change the lives of the people we serve. In fact, if our financial spreadsheets are off by even one penny (no exaggeration here), we are not paid until we can justify that one cent. Despite the fact that we had already paid upfront costs to operate the program.

To keep charities alive and operational, funders should decide  what results they want to see based on the dollars paid to that charity. So when they are auditing the organization, they are making sure the services are high quality and the outcomes achieved reflect the contract.

Then, let the agency decide how best to use its contract revenue to fund programs, overhead and other operating costs. Restricted line item budgeting results in more work for both funders and nonprofits, and does not allow the flexibility needed to change course if necessary. It also often results in some of the money being unspent or returned to the funder because it couldn’t be shifted from one area, say supplies, to other more needed expenses, like transportation. Judge programs on the results of the work – not on how much is spent in one area over another.

Here in Los Angeles, both the city and the county are planning to invest millions of dollars into addressing the homelessness crisis. Much of that funding will be distributed via contracts to nonprofit organizations that serve and house people who are homeless.

But if these funding entities continue to use an old contractual paradigm that won’t allow organizations to fund all of their costs, they will only be increasing  the risk of more low-overhead organizations closing their doors to those they serve. And that makes the fight to end homelessness that much harder.