“Art the Pig,” Hello Angel Creative

I have spent half my career working with for-profits and the other half with nonprofits; trust me, the nonprofit leaders have it much harder. The biggest reason is the dysfunctional nature of their funding, particularly from the government. Though there are myriad types of government agencies spread across local, state, and federal levels contracting with a wide range of nonprofits, this is a fair characterization of their funding relationship:

Nonprofits: “You give us insufficient, cost-reimbursement-based funding that is inflexible, prone to delay, and administratively burdensome. We need more money, paid earlier with greater flexibility, and less paperwork. The current situation is not sustainable.”

Government: “We have many calls upon our limited resources. Our procurement rules are in place to reduce costs and mitigate risk. The requests for proposals (RFPs) you respond to are voluntary. You say that we fail to cover your ‘true costs’ and that you will not survive, yet here you are.”

In response, nonprofits have, for decades now, focused their advocacy on arguing for more money on the basis that current funding levels do not cover their “true costs,” defined as covering the costs to deliver the services in question, including an allocation that fully covers the associated indirect costs. While it is vital that nonprofits understand their true costs—and many do not, ironically, because their accounting systems are oriented around contract and grant tracking rather than full program tracking—the more-money strategy is largely a losing one for nonprofits.

Why “More Money” Doesn’t Work

The more-money approach is generally a loser for several reasons:

  • The government already knows that most contracts do not cover nonprofits’ associated costs. In fact, some contracts are specifically designed to ensure that this is true; for example, many contracts with New York State’s Office for People with Developmental Disabilities have deficit-based rates. Yes, it’s true that the government does not ask for-profit companies to build bridges for less than cost, but nobody offers.
  • In a fragmented nonprofit market with low barriers to entry, there will always be nonprofits that take cost-minus contracts. They could do this from a mission-driven desire to do the work and a concomitant willingness to subsidize it with philanthropy, from ignorance of their “true costs,” or because it can be rational to work for less than “true cost” but more than short-term marginal cost.
  • Government will be cost-focused for the foreseeable future. Outcomes—let alone prospective outcomes—are difficult to measure, making them difficult to use as the basis for awarding RFPs.

The more-money strategy is more likely to succeed when government has an independent reason to care about nonprofit costs. This usually means it has a specific reason to care what nonprofits pay their people, as most nonprofit costs are wages and benefits. Such reasons might be fairness, if similar people are doing identical work at higher wages as government employees (for example, teachers); humanitarian concern, if the current funding levels support only near-poverty wages; power, if the staff benefit from collective bargaining; or politics, if the associated nonprofits have political clout (e.g., charter schools in some jurisdictions).

Government may also be receptive to pleas for more money when it needs nonprofits to enter a new area quickly. This need could be in response to a sudden court decision, a crisis, or political pressure.

In the absence of these independent motivations, government will only voluntarily pay more in the unlikely event that significant organizations start failing in ways that leave clients without essential services. Yet nonprofits have proven remarkably resilient. Nonprofits have limited fixed costs, and their staff are often all too willing to absorb distress (furloughs, pay reduction) so the mission can continue. Government scrambles to pick up the pieces when a group begins to totter rather than thinking about and addressing the structural reasons for its distress.

Focusing on Better Money

Although the amount of government funding has been the focus of most nonprofit advocacy, the nature of the funding is often equally if not more troublesome and may be more amenable to creative problem-solving if nonprofits, government, philanthropy, and other supportive stakeholders work together. This type of collective, multi-stakeholder problem solving may be easier in the COVID-19 era, which has already seen considerable collaboration and further highlighted the importance of essential, nonprofit-delivered services.

There are two aspects of the nature of government funding that create undue financial hardship and higher administrative burdens for nonprofit organizations: delayed cash flow and inflexibility. Both have complex dynamics but are amenable to creative solutions that are being tried now, and could be encouraged more broadly, through multi-stakeholder advocacy.

Cash Flow

Most government funding comes in the form of cost reimbursements. Nonprofits need to get money, spend it, submit vouchers evidencing that they spent it properly (usually against a detailed, pre-approved budget), and then wait to get reimbursed. In theory, cost reimbursements—if paid promptly—do not create cash flow problems for a steady-state nonprofit, but in practice they do, since there are delays, nonprofits are not always in a steady state, and single contracts may comprise a significant percentage of an organization’s total operating budget. Advances against contracts can help ameliorate the cash strain, but these only apply to contracts that have been registered, which often happens after the work must begin.

For-profit businesses typically stay afloat while waiting to get paid by borrowing money against their future payments. Unfortunately, this is hard for nonprofits because would-be lenders see four problems:

  1. Noneconomic size: Most nonprofits have budgets under $5 million. Assuming they get two-thirds of their revenue from government funding and need 60 days of float, the maximum financing need for these organizations is only $500,000, and per contract it is much less. Loans this size are unattractive even for CRA-motivated banks and CDFIs, which instead tend to focus their efforts on chunkier real estate deals.
  2. Perceived risk: From a credit perspective, nonprofits have only quasi-receivables from the government: they get paid only if they do the service, and then fill in the paperwork properly, and if the government agrees to pay them, and then gets around to doing so.
  3. Non-assignability: Nonprofits are generally prohibited from assigning the payments they are due from government to lenders. So, lenders face the additional risk that even if the nonprofit gets paid, it may not pay them. This precludes nonprofits from factoring their receivables, which is the traditional way that small businesses (e.g., most nonprofits) with creditworthy customers (e.g., government) get access to credit.
  4. No upside: Even if a lender were willing to take these risks, the appropriate risk-adjusted interest rate would be too high for nonprofits to pay, given that government seldom reimburses interest costs and paying interest to private lenders is an uninspiring use of philanthropy.

However, these issues can be mitigated if nonprofits, stakeholders, private funders and government work together to create multi-stakeholder, place-based lending funds. The basic structure of these funds is simple:

  • Risk reallocation: The government takes the first losses, and philanthropy (through program-related investments or recoverable grants) takes the second losses, allowing commercial lenders (the CRA-desks of commercial banks and CDFIs) to come in with less risk than the underlying loans.
  • Pooling: The lenders make larger (e., more economic) loans to the pool, which then makes smaller (i.e., less economic) loans to nonprofits.
  • Process: The government works to allow de facto assignment of the contracts and designs procurement-compliant ways to indicate that a given contract is eligible to be factored and that the payment can be assigned. There is no legal reason why this could not apply to unregistered contracts.

One very successful example of this type of fund is the New York Acquisition Fund. The Fund for the City of New York also operates this type of pool,  though at a fraction of the scale that the city needs. In New York, there was a failed effort to launch a larger multi-stakeholder “Community Resilience Fund” in 2013 at the end of the Bloomberg Administration, which would have included government, foundations, CDFIs, and banks. At a moment when nonprofits need all the help they can get, the next mayor should immediately revive it.

Inflexibility

Although many board members don’t understand it, most government contracts are actually multiple contracts in one. For example, a $1 million nonprofit contract might stipulate that the money be spent in exactly six ways (e.g., $90,000 for two senior staff at $45,000 each, $350,000 for ten social workers at $35,000 each, $50,000 for rent, etc.), separately accounted for against six line-item budgets with limited ability for the nonprofit to move money between categories without formal approval. This type of contract means that many nonprofits—already small to begin with—are forced to operate like a collection of even smaller businesses, with all the associated management, financial, and staffing headaches. Managing these sub-units is a necessary competency of any successful multi-service agency. While for-profits sometimes voluntarily divide themselves into smaller units to make management easier, money remains fungible between the units.

Despite the suffering that these types of rigid contracts inflict on nonprofits, there is no prospect of moving to fully fungible, master contracts that span multiple government agencies. Often the mission or geographic spread of a nonprofit does not correspond to what a particular government agency wants, or is even allowed, to fund. Government also has reasonable control, reporting, and risk-mitigation needs that are instantiated—albeit painfully—in prescriptive inflexible contracts.

However, government agencies that have had multiple contracts over many years to high-capacity nonprofit partners might consider modifying these contracts to allow for flexibility across categories within certain bounds; these bounded-flexibility contracts might require after-the-fact reporting but not pre-approval. If a government agency has an ongoing, multi-contract relationship with a nonprofit, it has many extra-contractual ways to ensure that it “behaves.” Where government has numerous, often one-off contracts with many small groups, it might consider bundling them into a single master contract with a larger, higher capacity intermediary that would then sub-contract the work.

These types of approaches require revisiting the implicit assumption that all nonprofits must be treated the same regardless of size, history, or capacity, an assumption that results in a lowest-common denominator, one-size-fits-none approach that leaves everyone exhausted.

…

In the catastrophic context of COVID-19 and the resulting economic downturn, the government needs essential services to continue, and it needs to create jobs. Nonprofits can do both. At the same time, pressure on state and local budgets may make things tough enough that significant numbers of nonprofits fail. This confluence of pressures presents an opportunity to improve the dysfunctional government-nonprofit funding dynamic. COVID-19 has already yielded an unprecedented amount of collaboration among funders as well as growing interest in structured “impact investment” solutions. Nonprofits and their allies should strike now, advocating collectively for more timely and fungible resources for essential community services.