It is not enough to do good. It must be done well.
āVincent de Paul (1581ā1660)
What are we to make of for-profit charities like Google.org or nonprofit corporations like the furniture purveyor IKEA1 and (before 2006) that icon of American capitalism, the New York Stock Exchange? These crossover examples serve to remind us that nonprofits and for-profit businesses have much in common. However, their rarity also indicates fundamental differences.
Finance Fundamentals for Nonprofits sheds light on similarities and differences between nonprofits and for-profit businesses. It is intended to provide a foundation in nonprofit finance for graduate students, assist nonprofit managers, and instruct corporate executives on nonprofit boards. It does not delve into finance techniques that are the same in nonprofit and for-profit businesses.
The bookās subtitle (Building Capacity and Sustainability) signals its emphasis on two concepts of particular importance to nonprofits. Whereas for-profit managers are concerned with maximizing their firmās market value, nonprofit managers may have many financial goals.2 Finance Fundamentals for Nonprofits proposes that nonprofit managers should be primarily concerned with having the financial capacity their mission requires and sustaining it over time.
Financial capacity for a nonprofit consists of the resources necessary to seize opportunities and respond to threats.3 The amount needed depends on its mission, service delivery method, operating environment, and risks of potential adverse economic events. Maintaining assets takes time, effort, and money, so managers choose a capacity level that balances the costs of maintaining capacity with its benefits.
Financial sustainability is simply the rate of net change in financial capacity. It is a clear-cut issue for most profit-maximizing businesses. By maximizing profit, assets grow as fast as possible and sustainability takes care of itself. However, sustainability is an issue for nonprofits that trade off surpluses (the profits of nonprofits) in favor of serving more people and serving them better. They must take care not to spend too much on such worthy objectives because over the long run they must be able to keep their assets in good shape and maintain their reserves at a level commensurate with anticipated economic risks. A sustainability principle requires consistency between the short run (as measured by annual surpluses) and the long run (as measured by asset growth). This is the subject of Chapters 6 through 9.
A major difference between nonprofit and for-profit financial management is that many nonprofits generate income from sources other than selling goods and services as for-profits do. Such alternative income includes gifts, grants, dues, and income from endowments. Even if a nonprofit has no sources of alternative income it can choose to develop them, which gives it strategic options foreclosed to a for-profit firm.
Financial models used by for-profit managers must be modified before applying them to nonprofits, because alternative income reverses financial logic. In for-profit firms production creates revenue through sales; but in nonprofits with alternative income the amount of income determines how much can be produced.
This chapter introduces the bookās agenda, beginning with a discussion of alternative definitions of nonprofitāor not-for-profit, as accountants call themāattempting to discern the essential character of ānonprofitness.ā Then it describes the intrinsic similarities and differences between for-profit and nonprofit corporations, highlighting the advantages and disadvantages of the nonprofit type.
A few technical terms are necessary for this discussion. Later chapters on related topics will define them. In the meantime, readers may consult the Glossary at the end of the book to clarify unfamiliar terms.
What Are Nonprofits?
The simplest and most common definition of a nonprofit organization is one that is ābarred from distributing its net earnings, if any, to individuals who exercise control over it, such as members, officers, directors, or trusteesā (Hansmann 1980).4 The prohibition on distributing net earnings to private parties is widely known as the nondistribution constraint. The principal shortcoming of this legalistic definition is that it makes no reference to noneconomic values, which is the social justification for nonprofits. The United Nations (UN) uses a more robust definition, which defines nonprofits as:
organizations that do not exist primarily to generate profits, either directly or indirectly, and that are not primarily guided by commercial goals and considerations. [They] may accumulate surplus in a given year, but any such surplus must be plowed back into the basic mission of the agency and not distributed to the organizationsā owners, members, founders or governing board. (United Nations 2003, 18)
This definition is not explicit about the noneconomic values because it must apply in all countries despite their cultural differences. Finance Fundamentals for Nonprofits uses the UN definition because it implies the primacy of values. In the United States, tax exemption laws address nondistribution through intermediate sanctions and keep nonprofits mission-focused by specifying acceptable exempt purposes (see Chapter 5).
For-profit firms may espouse social values, but these values usually are secondary to maximizing a firmās economic value or they are instrumental toward that end. The Body Shop and Ben & Jerryās are well-known examples of values-centered for-profit firms, but it is significant that they earned their reputations before going publicāmeaning before selling stock on a public exchangeāand acquiring investor-owners.
Social values are the business of nonprofits. As Rose-Ackerman says, nonprofit customers ā...