Recurring Rip Currents,” Peter Kaminski

Hailed as a potential game changer, ImpactUs fell apart eight months after opening even though the impact-investing intermediary had the backing of the MacArthur Foundation, Ford Foundation, Kellogg Foundation, Open Road Alliance, Enterprise Community Partners, and City First Enterprises. Another firm is picking up the pieces, so it may not be a total loss, but why did the initial effort flame out so quickly? Here, John MacIntosh advances some tenets for nonprofits to follow to give their venture activities a greater chance of success.

ImpactUs, the broker-dealer for impact investments that recently shut down less than a year after going live, may be just another casualty of the flawed theory that intermediaries are a necessary precursor to healthy markets: an exactly backwards idea that funders nevertheless find enticing, perhaps since intermediaries are cheap and easy relative to underlying markets they promise to enable.

On the other hand, ImpactUs looks to have had a lot going for it: strong funders (Ford, MacArthur, Kellogg, Enterprise, City First Enterprises, and so on), high quality issuers (e.g. Low Income Investment Fund, Coastal Enterprises, among others), an experienced management team, and enough residual value that MissionPoint Partners recently announced that it was acquiring the assets. So maybe ImpactUs was a good idea that would have succeeded—or at least taken longer to fail—had it been approached differently. And while I don’t know the details, what I do know from similar situations suggests that many nonprofit earned-income ventures (“NEIVs”)—organizations launched with a big dollop of philanthropy but then expected to “make it” on earned income—are not approached in a way that maximizes the odds of success.

A venture-backed startup works like this: An entrepreneur has an idea she is passionate about and races around to early-stage funders looking for support. Funders decide whether or not to support her based on their pre-existing enthusiasm for the general idea, their confidence in her, and the price. The financing round closes if and only if a minimum quantum amount of money can be raised. Funders join the board. Reality intervenes. Things don’t go as planned. As expected, the organization needs to raise more money. The second funding round is more attractive than the first one since, insofar as the organization has demonstrated some success, it’s now less likely to fail, and funders are closer to an exit. But it’s also less attractive since it has a higher price. The funding round clears at a price where the fear and greed of funders are balanced. Funders exit when the organization is taken public or sold to a strategic buyer. If the organization fails, funders lose all their money, but for the good ones the losses on this deal are more than offset by the profits on others.

In my experience, nonprofit earned-income ventures work more like this: A small group of like-minded funders (or nonprofits) decide that a given organization should exist. They hire a consultant to confirm/inform their view. Initial grant funding is scraped together without an explicit all-or-nothing minimum, although it’s usually sufficient to support the organization until break-even according to “the plan.” Some initial funders believe “the plan” will work as expected. Others have supported the organization largely because their peers have asked. There is a vague belief that new funders can be found in the future, though it’s unclear who these might be or how they would decide whether or not to participate. Consultants or staff from the funder(s) provide operational support to the new entity until a full-time leader can be found. Things don’t go as planned. The organization needs to raise additional funds but struggles to attract new funders, who see little reason to participate given that they have not been “in” from the start. Other would-be funders truly like the idea but see no compelling reason to support it financially. Some initial funders balk at putting more money up. Others are happy to participate but reluctant to do more than their share. The organization limps along, restructures, or fizzles out.

This NEIV model violates five core tenets of startup funding:

  1. Without an entrepreneur, you have nothing. Entrepreneurs who can act confidently in unproven areas, overcome resistance and get things done are very rare. A plan without an entrepreneur is worthless. True entrepreneurs are reluctant to pursue other peoples’ plans. The role of the entrepreneur cannot be outsourced. Consultants bring a theoretical and/or activity-based mindset that is antithetical to the skills required to run a startup. An idea that funders dream up yet no credible entrepreneur wants to take on is a bad idea.
  2. The entrepreneur is at the top of the epistemic hierarchy. Entrepreneurs have the most relevant knowledge, funders come second, and consultants—other than in very narrow areas—third. An entrepreneur who truly knows less than a funder is not backable. A funder who truly knows more than an entrepreneur should change jobs.
  3. Don’t raise any money unless you can raise enough money. The initial funding must give the organization enough time to learn something definitive: either something allowing additional funding to be raised with reasonable certainty or so sufficiently damning that funders can confidently “pull the plug.” It is much harder to know what this “something” is in the nonprofit world of multiple, often incommensurate, programmatic outcomes than in the for-profit world where long-term outcomes—sales, profit, return on invested capital, cash flow—are in general agreed and more easily quantified. The second round of grants is always much harder to raise than first. The cool kids always want to go first. Grants are not driven by fear or greed, though impatience and boredom affect us all. There is no ability to change the price or other terms to entice participation, and nonparticipating funders can free-ride on participants. Nonprofit startups should be fully funded from the start with initial commitments of sufficient scale to support the organization through breakeven under all reasonable cases.
  4. Don’t expect things to go as planned. Most things will be worse (entrepreneurs are optimists), a few will be better, others will be different. Funders will have differing views of how things are going. The best way to judge is through involvement on the board and regular dialogue. A funder who believes in The Plan will be sorely disappointed. Funders must balance the inside view with the outside view.
  5. Create a workable nexus of cash and control. Decisions—often tough ones—may need to be made quickly, and in a startup, everything has cash implications. So, the organization needs a functioning nexus of cash and control. This is no problem if the people with the control and the people with the cash are the same people, or at least sit together on the board. But it’s a problem if the cash is controlled by a disparate group of foundation boards that cannot communicate and coordinate in real-time with one another or the organization.

And while NEIVs are rare, these same mistakes are often made by nonprofits starting earned-income activities—activities which, it is often hoped, will generate unrestricted income for the parent. (This is different from nonprofits deciding to differentiate the price of their service—nursing home beds, dance studios, boathouse space, math tutoring—based on ability to pay. This type of earned income is not a business; it’s a pricing strategy.)

As a general approach, this is insane. Most nonprofits have very little cash, little “monetizable” intellectual property, and staff (and funders) without much startup experience. Further, they are approaching social enterprise from the tougher direction. It’s easy to make a business more like a nonprofit (i.e., more social): increase expenses. It’s trickier to make a nonprofit more like a business. But if a nonprofit is going to start an earned income activity, they should increase the odds of success by following the tenets.

After 50-plus years of battle testing, these tenets are beyond dispute in the for-profit venture capital community. So, why aren’t they followed by most nonprofit startups? Because it’s more difficult. Social entrepreneurs may still be harder to find than their for-profit peers. Consultants do sometimes bring valuable knowledge. Committing against uncertain all-or-nothing funding is difficult given cash-out-the-door foundation grant budgets. It does seem foolish to commit never-to-be-gotten-back grants to an organization based on worst-case needs. It feels dishonest to recommend a grant based on a plan that you don’t expect will be achieved. Funders with board seats can feel uncomfortable.

But on the other hand, there are fellowships and programs that indicate that social entrepreneurs will come knocking on the door of a funder expressing an interest in finding them. The cash-out-the-door problem is solvable with DAFs or escrow agreements that allow money drawn down on an uncertain schedule to be treated as a one-time grant. Over-commitment doesn’t apply to funding made as a PRI or a recoverable grant which can be returned if it turns out that some of it is unneeded. And there is no structural conflict of interest that would prevents funders providing long-term, general operating support from taking board seats.

What does this mean? For foundations, it means advertising those areas where they are predisposed to fund startups in the hopes of finding simpatico entrepreneurs, then having startup appropriate processes to handle those that come in. For nonprofits, it means structuring earned-income initiatives as if they were independent entities, with concomitant requirements for dedicated risk-tolerant funding, leadership, governance, and the like.

Philanthropy and unrestricted net assets are the most precious forms of capital, and there are many low risk ways to put them to good use. Every flawed startup idea that squanders philanthropic capital has a high opportunity cost. So does every good idea that fails through poor execution. Startups are not for the faint of heart, and those unwilling (or able) to do them right should refrain from doing them at all.