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Nov 24, 2010

Do You Understand the Nonprofit Business Model?

A clear understanding of the nonprofit business model continues to be so elusive among both donors and nonprofit board members. A donor cannot know how his or her gift benefits a nonprofit without understanding the underlying business model. And a nonprofit board member cannot make good decisions in the absence of a clear understanding. This is remarkable because neither donors nor board members would tolerate vagueness in their decision-making for for-profit organizations.

In my upcoming column for Business First I provide a 900 word summary of the basics of the nonprofit business model. The first concept to master is that overall budget balance provides no useful information about the success of a nonprofit. The second concept is that “cutting to the bone” has nothing to do with effective philanthropy. If cutting to the bone means inadequate physical and managerial infrastructure, then it really means inefficiency. No business saves itself into prosperity. Same goes for nonprofits.

The third concept to master is that a nonprofit is a conglomeration of two businesses.  The first is intentionally a money-loser. That is why the nonprofit is a 501(c)(3) charitably organization. In the first business the nonprofit provides services that the market-system is unable or unwilling to provide but that the community expresses a strong need for that service. Budget balance or profitability in this business is an intentional decision to underserve the community or to triage the community and exclude some citizens from obtaining that service. I view that as a failure to fulfill the primary duty of a nonprofit: to be a reliable provider of a useful community need.

The second business provides for-profit services in order to earn profits that can be used to support the services of the first business. Every standard applied to a for-profit applies to this second business: positive margin, adequate return on investment, positive cashflow, etc.

Success for a nonprofit has three components and, therefore, three measures.

1. The first business is successful when it demonstrates a value proposition that its services are fulfilling important community needs.

2.  The second business is successful when it earns profits that have a return on investment that is competitive by market standards.  

3.  The nonprofit as an organization is successful when the profits of the second business are sufficient (a) to cover the operating deficits of the first business, (b) to provide adequate liquidity to the overall organization, and (c) to fund a stabilization reserve sufficient to sustain the services of the first business during an economic recession or other financial crisis.  

In my seminars and retreats, I have found many board members have difficulty understanding that profitability in the business is actually an indicator of mismanagement.  It is easier to understand if I said that making money on providing shelter to homeless people is perverse: more beds could be provided or charges for access could be lower than the “profitable” business is choosing. That is plain wrong for an organization that claims a 501(c)(3). Run a separate hotel to make money and use that to provide even more beds for the homeless at a loss that can be covered by the hotel.

For more examples, look for my column in upcoming issues of Columbus Business First. And reread Chapter 8 of Linking Mission to Money and the chapter “Profit versus Passion” in More than Just Money: Practical and Provocative Steps to Nonprofit Success.

Click here for a list of my other articles published in Columbus Business First.