The Case for Debt Capital - Expanding Financial Resources for Fiscal Sponsors and their Projects

Why now? What’s at stake?

As 2020 draws to a close, the pandemic rages on, though with some hope in sight. The federal Payroll Protection Programs (PPP) and related relief funds, however, are about to run out for most nonprofits, with the path to a new package from congress still unclear.

The coming months are likely to be dark and hard, both for the mental and physical health of our communities and for the financial health of nonprofits. Despite the many challenges our sector has faced to date, we are only beginning to see the real financial and other impacts of the pandemic on organizations. Prior to COVID, the Nonprofit Finance Fund reported that roughly 40% of all nonprofits have less than 30 days cash on hand. More recently, La Piana Consulting has tracked a surge of interest in mergers and restructuring, and Candid study reports that between 3% (best case) and 38% (worst case) may fold as a result of pandemic stressors.

The smaller nonprofits that make up the vast majority of our sector are and will be the hardest hit, as they have little in the way of safety net, both in staffing and finance. Nearly 900,000 of the estimated one million nonprofits operate with budgets below $500,000. And contrary to popular assumption, these small organizations do the vast majority of our sector’s work.

Despite the dire circumstances and extreme pressures on the sector, we predict that our losses in the will skew toward the more optimistic end of Candid’s assessment. There are two reasons.

First, there is already a lot of positive “churn” and activity in our space. The pandemic, climate change, and the general assault on human rights and social justice waged in recent years has led to the creation of myriad initiatives, led by new generations of nonprofit leaders. So, while some organizations will disappear, many others are stepping into the fray.

Second, the greatest single resource of our sector is the people who drive it—mostly (and unfortunately) through contributed (uncompensated) time, energy, skills, and knowledge. I would estimate that the value represented by the donated time and knowledge of our nonprofit workers is far more valuable than all of our philanthropic endowments, individual donations, and government funding streams combined. This fact is both a wellspring of hope and cause for despair. It gives us hope, as people will be the reason the work of our sector survives the pandemic. We despair, because we must ask ourselves: at what human cost?

Nonprofits end not when the money runs out, but when the motivation runs out. Prior to our current crisis, the money-for-time balance in our sector has long been severely imbalanced--not enough money to cover the true cost of delivering impact. Now I fear we’re witnessing a period of extraction of uncompensated human effort on an unprecedented scale. And once spent, the cost of time cannot be recovered. We need more finance, and right quick. Enter capital into the conversation.

Getting our terms straight.

Most nonprofits raise and/or earn the money they need to cover core operating expenses. (At least, that’s the idea.) Anything left over that is not restricted to a special purpose is capital. In the for-profit world, this would be called “profit”. But since nonprofits can’t profit, they’re just net assets. (Oh, the power of words!)

These net assets are also sometimes called capital, as in “working capital”--funds you can use to manage bumpy cash flow, or save for the proverbial rainy day. “Capital” is distinct from “normal” operating revenue and expenses. It is the money you need to invest in additional staff, new technology, R&D for a new program, etc. toward the end of building capacity. Those new investments will help serve more people or generate more income, hopefully. Capital funds are also a form of insurance: they can help weather external impacts (like COVID), recover from unpredictable losses, and other negative events. In addition to net assets, capital for nonprofits most frequently comes in the form of restricted gifts or grants under the moniker of capacity building. In fact, this grant capital is the form that our field (funders and nonprofits alike) find most amenable. Capital and capacity building are joined at the nonprofit hip.

The terms “capital”, “assets”, and “investments” come from the extractive (and often exploitative) world of free-markets and private interest, in other words, capitalism. For this reason, in the commoning world, we don’t talk about capital, but commons resources. These are the resources (money, real estate, equipment, land, etc.) a commons brings into its embrace to steward for the benefit of a defined, but open community. For the purpose of this post, though, commons resources, assets, and capital are synonymous. While the free-market overtones of capitalist lingo are undesirable, shifting language is a slow process!

It’s all about timing and options, and we need to include debt in the mix.

Responsiveness in capital funding and finance has always been a critical weakness of our sector, and will become even more so in the months to come. We need more sources and streams of money or “supply of finance”, to use a fancy phrase. And we need it when our organizations need it, not when the suppliers (funders, donors, lenders, government agencies) want to supply it. This has always been and remains perhaps our sector’s greatest structural problem. While grant funding prevails as our chief form of capital, it has a number of problems discussed below. Low- or no-interest loans (short-term, revolving credit, and such) need to be added to the picture. As we look to increasing cadence of capital needs, we cannot afford to turn away from debt as a form of capital. How are nonprofits using loan capital? Research by American Nonprofits, a “small-cap” lender to nonprofits in California yields some insights.

BRIDGING – Providing temporary cash flow relief against contracted receivables (grants or service contracts) or anticipated income (from proven programs or services).

The Ecosustainability Project has two government contracts and a grant totalling $250,000 that they have yet to receive, but need to make payroll next week. They can borrow against these contracted receivables and make sure their people are paid on time!

RECOVERING – Funds for retiring debts and liabilities that resulted from broken business models or external events, assuming a sustainable business path forward has been defined and committed.

Very Experimental Theatre Company was hit hard by the pandemic, having to cancel a whole season. They need some funds to take care of aging payables and keep their core staff employed, while they pivot to virtual programming and plan for future live events. To get through, they want to borrow funds at no interest, with the potential to convert some to outright grant, if they cannot fully repay the loan.

SCALING - Funds for investment in staff and infrastructure capacity in advance of new or increased revenue streams and demonstrable external demand for/interest in growing programs.

Community Healthcare Partners, a “Model A” comprehensive fiscal sponsor, has several large new projects waiting to spin in, but must invest in staff and systems before bringing them onboard. To move quickly, they want to secure a low-cost loan, leveraged against anticipated income from the new projects.

PIVOTING/INNOVATING - Funds for supporting organizational change or innovation in advance of new or increased revenue streams and/or savings and cost efficiencies.

The Advocacy Project has been working on its social justice advocacy and has developed a bold new online platform and fundraising campaign strategy, but needs to invest in implementing it ahead of projected income. They would like to explore low-cost debt as a quicker path to finance. Time is of the essence!

As the above suggests, there is “good debt” and “bad debt”. Good debt is debt with a thoughtful and viable plan, low/no cost, favorable terms, and means of repayment. It’s solving a short-term problem with a clear path forward, not plugging an unaddressed structural deficit or operating failure. Bad debt is the latter: loans without a clear exit or high cost and punitive terms that threaten to burden the nonprofit with crippling cost and added risk.

There are some roadblocks and smaller nonprofits suffer the most.

Small to mid-sized nonprofit organizations and projects, such as those that often find a home in fiscal sponsors, are particularly disadvantaged when it comes to responsive financial resources. Calls for emergency support go unheeded. Opportunities are lost to bad timing.

Racial Equity & Access: Communities of color and other marginalized groups are most frequently excluded from accessing loans, and underwriting models are rife with negative racial biases. According to a May 2020 study by Echoing Green and Bridgespan Group, African American small business owners are 5.2 times more likely to be denied a loan than their white counterparts. Black and Brown-led early stage nonprofit organizations also exhibit disparities in income as compared to white-led organizations: 24% less revenue and 75% fewer unrestricted net assets. Among those examined in the study African American-led start-ups received $20 million less than white-led organizations and only 11% of “big bet” philanthropy investing in social change initiatives went to organizations of color. While these latter stats concern income and grantmaking, the well-documented and historical disinvestment in and exclusion of leaders of color and their organizations contributes to a vicious cycle of severe undercapitalization.

Awareness & Debt Aversion: There are sector-wide cultural prejudices against nonprofits taking on debt, and related, lack of awareness or knowledge of how to think of debt as a solution (not just a “problem”) in the context of nonprofit finance. Funders and donors are quick to look askant at debt on a nonprofit balance sheet, usually assuming the worst. Unfortunately, they are often right to assume the worst, as much of the debt we see in our sector is the result of structural deficits, unforeseen events, or the natural operating fragility of any organization, regardless of size. In fact, we see most carried nonprofit debt as the direct result of the undercapitalization, not mismanagement. It’s a negative cycle. Lack of capital means lack of any margin for operating error, which leads to the incursion of debt, should a financial assumption not pan out. The preponderance of “accidental” debt in our sector has made debt into a four-letter word. We can’t start to add this form of finance to our toolkit, until we can wield it with greater positive impact and more knowledge and facility.

Lack of Supply of Finance: There is a virtual desert of “small cap” lending, which generally runs between $10,000 and $100,000 per loan. This realm of lending sits between micro-lenders like Kiva (though Kiva will write loans greater than $10,000) and other more conventional lenders, who start in the $100,000+ loan range. Research by American Nonprofits, has shown tremendous need for short and medium-term loans between $10,000 and $100,000 among small and mid-size nonprofits. That is the sweet spot.

Foundations and government are slow to make grant decisions and respond to complex needs and situations. Smaller organizations tend not to have major donors capable of five-figure (or larger) check writing. Micro-lenders, such as Kiva, often employ crowdfunding for generating loan capital, greatly limiting responsiveness. Other nonprofit lenders, such as Community Development Finance Institutions (CDFIs) may be a bit faster and more responsive and have higher appetite for risk, but also have high lending thresholds and high loan costs as a result. Most CDFI’s and national nonprofit lenders, such as Nonprofit Finance Fund, won’t lend less than $100,000 (or more). And these days, nonprofits can practically forget getting a loan from a commercial bank.

Collateral & Creditworthiness: Finally, lack of collateral assets and reliable cash flow to secure operating loans hold smaller nonprofits back from borrowing. Most nonprofit lending still follows commercial banking culture and favors loans secured by assets with established markets, such as real estate, cars, and machinery. Even when nonprofits have assets to offer, such as endowments or real estate, the charitable nature of those assets prevents them from being viable collateral. A bank doesn’t want to foreclose on a homeless shelter! And small nonprofits (in particular the 88% of organizations operating below $500k/year) are seen as too financially fragile to take on any amount of debt, though this may not always be the case.

Fiscal sponsors, as commons managers, can change the loan-to-grant capital game.

Fiscal sponsors are uniquely positioned to address the challenges above and change the capital game both for themselves and their projects.

Distributing Authority: Just as philanthropy is re-examining who makes decisions and how in an effort to dismantle white supremacist structures in grantmaking, there is the same urgent need in nonprofit lending. Underwriting and risk assessments should be made by local community stakeholders with close knowledge of and relationship to the organization or project. Micro-lender Kiva has demonstrated that locally held, social and interpersonal connections (their “trustee” model) make the best loan management relationships. This has led to a more than 95% repayment rate for Kiva’s loans. Similarly, fiscal sponsors could organize and facilitate community-driven criteria and underwriting/grantmaking processes for their capital funds.

Sharing Risk & Increasing Access: Fiscal sponsors are structures for sharing risk, which can result in increased access to loan capital for projects that one their own would look too risky. For “Model A” sponsors, the sponsor is the true borrower on behalf of its projects, allowing smaller projects and start-ups access to lending through leveraging the sponsor’s net assets and greater scale of cash flow, among other potential positive underwriting factors. This presumes, of course, that the sponsor is capitalized and demonstrates a healthy overall financial position. By leveraging scale and the collective capacity of the sponsor, and engaging in thoughtful and intentional financial analysis with project leaders, smaller, start-up, or more vulnerable organizations might access more responsive and low-cost capital for their mission needs.

Ensuring Responsiveness & Ongoing Education/Support: The close relationship between sponsors and projects enables rapid risk assessment, data gathering, and decision making. Much of the delay in grantmaking and lending alike is owing to the challenging process of accurately assessing risk and feasibility from afar. Fiscal sponsors not only have ready access to the financial and other data they need to assess whether capital is warranted, they also know the people behind the project. This is perhaps the most critical factor in assessing creditworthiness and risk. Do you trust the project director to make good on the loan? As we saw with many sponsors in the early days of the COVID pandemic, sponsors have a bird’s eye view that permits them to evaluate vulnerability in their community of projects quickly and set in motion stabilization efforts at scale. Lastly, and very significant, ongoing technical support and financial knowledge sharing is built into the fiscal sponsorship relationship. Sponsors should be in a position to help projects and their leadership overcome “debt aversion” and apply the appropriate analysis to make an informed financial decision. Once a loan is made, if the project or “sub-borrower” runs into trouble, there is a ready hand to help solve the problem.

Leading Fund Development: Most critically, fiscal sponsors can lead the way in developing internal and cooperative loan funds with a mix of outright grants, “recoverable grants” (a.k.a. no-interest loans), and low-cost debt. Already, some larger fiscal sponsors fortunate enough to have developed cash reserves or commercial lines of credit provide a vital cash flow management function to those projects reliant on reimbursable government funding. Some of our oldest fiscal sponsors, such as TSNE MissionWorks and Urban Affairs Coalition have long held their ability to provide collective revolving capital to their communities as a major area of positive impact.

Undercapitalization has been a topic of conversation in the funding sector for several decades, with little progress in addressing the problem at scale. Fiscal sponsors offer a potential pathway to providing capital--both loan or grant funds--at scale by raising capital that effectively capitalizes all of their projects through one loan-to-grant fund: collective capitalization. This can make for a compelling argument to funders: in providing a fiscal sponsor (or group of sponsors) with capital to lend and grant, they are capitalizing tens or hundreds of organizations at once, instead of one at a time.