When I first started exploring the concept of a microfoundation, the idea was to create perpetual value for donations so that individuals can stretch the impact their contributions could make. As I started to explore further into that concept, I thought about how this could also be used for the nonprofits themselves. If the microfoundation’s donations continued to escalate beyond the contribution rate, what would happen if a nonprofit’s endowment applied this same feature: could the returns outweigh the donations? How would that affect the organization if that were to happen?
Before I explain my findings on creating a perpetual funding mechanism for nonprofit endowments, we need to first understand the funding constraints that nonprofits experience.
The Donor Bottleneck
Nonprofits have the thankless job of trying to convince people to give them money when they don’t get anything in return, and turn then around a year later and ask for money yet again. When a donor does give the non-profit money, they then scrutinize the organization as if they were an investor. This becomes problematic when the nonprofit tries to attract top talent to boost the effectiveness of the organization by increasing employee benefits, since then the donors ridicule them and complain that they, “Aren’t paying for you to send your director on vacation; but to go save children’s lives!”
Everywhere a nonprofit turns, it’s an uphill battle. Even when the mission is strong, and the team is competent, donor fatigue can set in and donors stop giving because they don’t see any tangible change; there are still starving children and homeless vets. Nonprofits continuously have to create new strategies to keep donor interest and provide a narrative that progress is being made, and sometimes it requires thinking outside of the box of donations entirely.
One of the more prominent innovations is social entrepreneurship, which is when a nonprofit in some capacity creates a profit-generating product/service that they can use that profit to supplement their operating budget. This is an excellent concept when properly executed since it helps the nonprofit to utilize market incentives to make it easier for potential donors to contribute. However not all organizations can create spinoff organizations and it’s also not a guarantee that the venture will even be profitable; it may just distract the organization from its mission and blow part of its operating budget as well.
Another method a nonprofit can take is to leverage a strong marketing campaign and make the organization a prominent brand that is easy to recognize. Lance Armstrong’s nonprofit, Livestrong, had a decade of being a prominent brand with the classic yellow Livestrong bracelets. There’s also the famous March of Dimes that puts on fundraising walks across the country. These methods can be effective in driving donations as it becomes about buying into a brand. The problem with this is that it ends up costing a lot to market a brand, and it begins to eat into the budget for the mission that donors are buying into.
Charity: Water Breaks The Mold
Nonprofits can also be disruptive innovators as well. Charity: Water took on some of the major issues donors have with nonprofits and reinvented what a donation dollar’s purpose was. Traditionally, a nonprofit makes a pitch about the good they are trying to accomplish, and may take a further step of trying to quantify the given impact a donation will have. We as donors see the need displayed and we may make a $100 donation to XYZ Nonprofit, thinking that $100 is going to straight to the field. The frustrating reality is probably about $30 of that donation is covering administrative costs and fundraising efforts. While that isn’t wrong in any way, because these organizations need to pay their staff, it’s frustrating as a donor to know that all our money isn’t being directly applied to the mission we’re supporting. Another issue that comes along side of this is the lack of transparency; we donate money thinking we’re contributing to solving a problem, but we don’t really know where that money actually ended up and how it was used.
Charity: Water attacked these issues head-on and proposed a crazy idea: What if 100% of your donation went right into the field, and you knew the exact water well that your donation went to help build and who exactly was getting to use that well? Coming from that mentality, Charity: Water founder, Scott Harrison came up with an innovative strategy: all administrative costs would come from a core group of committed large donors, and all public donations went straight into the field. They built an in-depth donation tracking infrastructure so that each donation would be linked to a particular project, and updates related to that project would be sent back to all donors.
Charity: Water’s strategy for extreme transparency has been effective in building a passionate community of supporters, but there is still the bottleneck issue that it is hard to draw out repeat donations from donors consistently. Charity: Water’s primary source of donation generation is through birthday campaigns, where individuals “donate” their birthday gifts to Charity: Water and everyone who was going to buy them a present donates instead. It’s been an effective model to tap into the sensational drive that campaigns provide, but operating on a large set of mini campaigns. The issue still is that many of these donors don’t become repeat donors, and Charity: Water has to rely on other campaigns to keep the donation drive going.
The Perpetual Value Solution
The core issue that nonprofits deal with is the lack of a consistent income stream. They don’t provide a service that reinforces the buying behavior, so why not turn to passive income? What if nonprofits built an endowment feature in their finances that starts pooling a small percentage of its donations that wouldn’t have a material effect on its projects, and it took that money and invested in long-term assets? Based on the concept of the perpetual value method, an organization would be able to cash out 5% of the account value at the beginning of the year, meanwhile it would incrementally increase the percentage of donations are being allocated to the endowment fund.
Endowments are not anything new for Nonprofits; all universities operate with an endowment fund with a management team that controls the investments and liquidates assets to fund school projects and scholarships. But it is the subtle difference in this method of the incremental increase in donation allocation that causes a dramatic change in the end. This theory states that when annual withdrawals paired with increasing contribution rates causes an indefinite use of a given investment dollar. The future value of a donation dollar can have perpetual use if its annual liquidation rate is less than the growth rate, along with being paired with partial liquidation of the following years’ investments. To learn more about this concept go to my previous post: https://grantxstorer.com/2018/perpetual-funding-theory-the-life-cycle-of-money/
Perpetual Value Method Demonstration
Let’s observe a simplified model of a hypothetical Nonprofit. To keep things easily observable, let’s say that there was a nonprofit that consistently received $1 million in donations annually over the next 30 years. But this organization decides to take 10% of their donations in year 1 and invests that into an endowment fund that averages 10% growth annually. The firm invest the $100k in donations in that first year and at the end of the year the fund is now worth $105k (assuming monthly investments of $8,333 and not $100k invested at the beginning of the year), meanwhile they were operating on a $900k operating budget.
At the beginning of year 2, the nonprofit can cash out $5,279 from the endowment fund and add that to the operating budget, meanwhile it increases its contribution rate by 2% annually, so now in year 2 it will invest 12% of its donations for that year into the endowment fund. While the nonprofit is only going to use $880k from donations that second year, the total budget is slightly higher at $885k with the $5,279 coming from the endowment.
The lump sum cash out from the endowment isn’t as big of an issue for the nonprofit as it is for the individual investor, because the typical individual’s budget would be more impacted by a lump sum as to an organization that operates on project schedules. But what the cash out does do for the nonprofit is help contribute back to the overall operating budget and as well as provide additional cash on hand.
The worst year (it’s not that bad).
As we observe the first decade of this project, the nonprofit will have to stomach that they are putting more into the fund than what they are able to take out and use in a given year, but those cash-outs do start gaining momentum. We saw that in year 2 the nonprofit put in $120k into the fund, and was able to pull out $5,000, which means they only got back less than 5% of their contributions in that year. But when we observe year 10, we see that the fund has grown to a balance of over $2.5 Million, and thus the nonprofit will be able cash out $106k, while they continue to put up $280k in that year. This means that they’re getting 38% of the money they put up back in that given year. Year 10 also marks the hardest year on the nonprofit’s budget constraints due to this program. While they have a fund balance of $2.5 Million, and they are getting to cash out $106k to add to their operating budget, the ending budget will approximately be $826k for the whole year even though they received $1 Million in donations that year. Just for simple math check, this is found by taking the sum total of donations ($1 Million), + fund cash out ($106,358) – investment contribution ($280,000) = $826,358.
Even though the nonprofit is investing 28% of its donations that year, it’s operating on 82% of its donations due to the added $106k back into the operating budget. The nonprofit is able to invest 28% while it only comes at a cost of 18% to their actual budget. Which again, 10 years into this and the fund has over $2.5 Million in it now.
Year 10 is a relatively difficult year, but this also a turning point for the organization. The fund has gained a critical size that each year moving forward, the overall budget will start to increase for the organization.
The Road to Self-Sustainability
After we hit the low point in year 10, we start to see the momentum start to shift; the gap between what we put into the fund and what we are are able to pull out continues to shrink, and when we get to year 22, we cross over a threshold that sets the nonprofit on a track towards self-sustainability.
If we jump to year 22, the nonprofit is still receiving $1 Million in donations, and they will be investing now 52% of its donations into the fund. That may seem like crazy amount to not be using towards the current projects, but when we look at the fund balance, we see that it now sits at almost $12 Million; and not only that, the 5% cash out means that $534,430 is going to be added back to the operating budget from the fund.
If you haven’t done the math yet, something special just happened: We started with $1 Million in donations, of which we’re going to invest $520,000 of it, while we get to cash out $534,430, meaning that our operating budget for the year is $1,014,430. Our operating budget is $14,430 beyond what we received for donations for the year.
If the nonprofit was able to hold on for those first 22 years, they now have reached the point where they can work with more than what they actually receive from donations, while they continue to sow the seeds for future growth.
I hope the significance of this is properly expressed: the nonprofit is going to invest $520k, and yet, they get an operating budget that is beyond what the actual donation base was. They are now getting paid to invest into long-term sustainability.
If the nonprofit was able to keep the fund up to year 22, every year afterwards continues to pay off handsomely. When we reach year 30, the numbers become almost unrealistic as the momentum of previous investments has propelled the fund into full on self-sufficiency mode.
In year 30, the nonprofit will be taking $680,000 of its $1 Million donations and investing it into the fund, but the cash out they receive from the fund is $1.1 Million. The proceeds from the fund now exceed what the nonprofit receive from donations, and on top of that, the overall budget for that year is now $1,436,004. The nonprofit now gets to operate on 143% of its donation base, while still investing almost 70% of what they actually received in donations.
There’s another critical element that has been in development that hasn’t been adequately expressed so far, and that is the investment fund balance. Up to this point, the balance of the fund has been used to express how much of the cash out the nonprofit could receive in a given year, but let’s observe that balance in year 30. In that 30th year, the fund balance is now over $24 Million, with the growth rate almost at $3 Million per year.
What this means is that the organization could lose literally 100% of its donors and they could just operate from the fund balance. In fact, if they never received another dollar in donations, they could just move the fund into a bank account, lock in that account balance, and ride out the account. The organization could literally keep a $1 Million operating budget for the next 24 years without receiving any donations and they would be perfectly fine with making payroll and funding projects.
This is significant not only because it provides a financial fallback plan, but because it ensures the viability of the organization for the foreseeable future. Nonprofits have a hard time attracting top talent because not only is the pay scale lower on average to comparable for-profit firms, but because financial stability is constantly a concern. While this is a concern in any organization, the concern is amplified by an organization that relies on benevolence as an income stream.
Think about the impact of having $24 Million in the bank as a security blanket; how much more assuring would that be to prospective executives to know that the next 24 years are guaranteed regardless of how much is received in donations? How much easier would it be for someone to commit to their passion if the fear that organization will cut payroll is gone?
Having a large fund balance creates a positive-feedback loop in that it creates security for staff, which then allows better talent to be drawn towards the organization, which further enhances its capability, which then feeds back into more donations and better projects implemented and adds even more to the investment fund.
This is a great theory and all, but I understand it’s a hard sell to tell nonprofits to do less today for the possibility of doing more tomorrow; on top of the fact that it may be difficult to convince donors that their money is not being immediately used towards projects. So one idea I have is to borrow from the Charity: Water model of Well Founders and bring together a core group of supporters who will take this initiative on. If a core team of donors can be bought into the long-term viability of the organization and are willing to put off some of the immediate impact for the future, the first couple of years could be primarily supplied by this group. Once the cash outs reach a notable threshold of perhaps 10% of annual donations, then does the organization start pulling from general donors to meet the increasing investment rate. Once the impact has been shown to donors, it may be easier for donors to buy into the formula.
Benevolence is such a difficult issue; it’s something we all desire to take a part in, but rarely do we find ourselves to be in a position to actively contribute without personal consequences. There still is so much need in this world and some of the greatest minds have dedicated their lives to improving the capacity of others against all odds. But with all the time and effort that has been put into helping others, every organization runs into the constraint of financial resources and ensuring long-term viability. I hope that this model I’ve laid out can provide at least a framework for others to think differently and to find innovative ways of combating financial scarcity.
If an organization can be prudent with its resources today, and operate at slightly less than optimal presently, it can harness the power of exponential growth to become something beyond any new donation drive or inspiring new director can provide. They just need to keep sowing those seeds; keep investing into the future and the future will take care of itself. It takes 30 years of dedication, which is a tall order, but if done effectively, it assures the next 30 years and beyond.