Five steps to starting an endowment: even smaller nonprofits can
A few years ago, GuideStar’s (now Candid’s) editorial director told me, “Most of our readers are convinced that endowments are good things. If their organizations do not have endowments, it’s because they can’t justify diverting money from programs to starting an endowment.”
It’s understandable that many nonprofits would feel that way. Most are very small, and nonprofits of any size often face demands that far exceed their resources. Smaller nonprofits also tend to view starting an endowment as an “end-game” financial instrument, money to be tucked away once they’ve achieved both success and stability … if they ever do so.
There is, however, another way to look at starting an endowment. As part of good financial planning that ensures an organization will be around in the future to carry out its mission. Here, is a five-step plan smaller nonprofits can use for starting an endowment—and putting itself on solid financial footing.
Step 1: Implement an organizational business plan based on responsible financial planning and management
In “Five strategic questions of non-profit organizational leadership,” Mark Vincent tells nonprofits that “managing from income and in real time stands in contrast to managing from your expenses and after you receive expense reports.” He describes a more fiscally responsible approach to nonprofit financial management that steers decision makers toward more sustainable practices.
Vincent makes clear that organizational income is far more than just money that goes directly to operating expenses. What about non-monetary contributions that lower expenses? Can the organization influence income because of reputation and goodwill? Can any capital be leveraged?
Second, does an organization try to raise income after setting expenses? Far better is to match anticipated expenses with a realistic expectation of income. This is in part to prevent stressful efforts to raise funds to cover money already spent.
Questions three and four concern the need to adjust spending percentages (programs/services vs. personnel vs. facilities). These should match a realistic income picture compatible with the organization’s mission. Crucial to such spending adjustments is a robust cash reserve to support and maintain the adjusted spending percentages. (We’ll save Vincent’s fifth question for later.)
Step 2: Sell your board and/or donors on the need for an adequate cash-reserve fund before starting an endowment
A Faculty Research Working Paper from Harvard’s Kennedy School of Government states, “Board members are responsible not only for mitigating fraud but also for ensuring that organizations have sufficient financial resources to fulfill its mission in the present and the future.” A cash reserve (aka working capital) addresses present-day fulfillment; starting an endowment supports the mission’s future.
Peter Brinckerhoff made a similar point in a very enlightening blog post from late 2011, noting:
CASH = OXYGEN. Cash buys you time to think, is insurance against funding cutbacks, lets you sleep at night assured you can make rent at the beginning of the month. Cash lets you manage rather than just survive.
And growth? Growth is funded by cash. … Money enables mission, but profits enable growth. Without profits (and profits that are retained, not immediately spent), you can’t grow.
In 2013, Brinckerhoff mentioned the common misconception that, for nonprofits passionate about their missions, a cash reserve is considered immoral. He suggested that any board members who are business owners consider how much cash their businesses keep in reserve. He claimed that it’s no different for the nonprofits they serve: both need cash reserves. “Operating with less than three to six months of cash … is crazy,” he declared. “In most cases for most nonprofits, having more cash is a good thing.”
Donors may well be more in tune with wise financial fundamentals than board members. As Joanne Fritz, the former nonprofit guide for About.com, observes:
Unfortunately, many people do not trust some nonprofits to use their donations wisely. By being completely transparent about your finances, you can make sure potential donors don’t have any reason to distrust your organization.
The third action item on Fritz’s list concerns the financial-efficiency ratings assigned by CharityNavigator—itself a 501(c)(3) nonprofit. CharityNavigator provides donors with information on the financial status of charitable organizations. CharityNavigator established its seventh and final performance metric, “Working Capital Ratio.” This suggests how long a charity’s programs can persist without new revenue and how well they can grow with adequate funding.
Charities depend upon their reserves of liquid assets to survive downward economic trends and sustain their existing programs and services. If a charity has insufficient working capital, it faces the difficult choice of eliminating programs or staff, amassing debts and liabilities, or dissolving. Alternatively, when giving flows, those charities that build working capital develop a greater capability for expanding and improving their programs.
Whether or not CharityNavigator rates your organization, being able to show potential donors that your nonprofit has some working capital can only enhance your reputation. If your books start showing a consistently adequate cash reserve over time, so much the better.
The larger point, however, is to have sufficient reserves to weather protracted economic downturns without cutting back on programs, services, and staff … or going belly-up. In his 2011 blog, Brinckerhoff writes, “Working capital … is the money you need between the time you make a product or provide a service and get paid.” If the bulk of your income is annual grant money, for example, and if you can’t accomplish your mission without that kind of grant support, then, in order to survive when that grant money is reduced or eliminated, you need as much as 12 months of working capital.
Step 3: Set up both the cash reserve and an endowment fund
I’ve previously written that “the three types of endowments (permanent, quasi- and term) provide financial flexibility and stability, and, despite popular misconception, can begin with very little money.” That declaration begs the question, how much is a “very small” amount? Very small, indeed.
The Financial Accounting Standards Board (FASB), in its “Financial Statements of Not-for-Profit Organizations,” uses illustrations such as “a donor contributed cash of $70 to create a term endowment,” and “a donor contributed cash of $200 to create a permanent endowment fund.” As long as a nonprofit sets aside any amount of cash, securities, or other assets as restricted or unrestricted net assets, whether donated or not, and accounts for them properly, it has an endowment.
So, even if you haven’t asked for donations earmarked for permanent or term endowment, put part of your income into a board-designated (aka quasi-) endowment, and keep your accountant in the loop. Like having cash reserves, showing potential donors your nonprofit has an endowment of any kind can encourage more donations of all kinds.
Finally, if you have a growing cash reserve, direct any excess funds from that reserve into your quasi-endowment. There, the unrestricted assets will remain available for emergencies.
Step 4: Look for investment managers who offer suitable strategies (in terms of historical return and risk) for starting an endowment and perhaps even the cash-reserve fund
Having established both a cash reserve account and an endowment fund, add to those assets regularly. Build up the amount of working capital until it’s equivalent to three to six months of expenses. (Whereas cash reserves might need to constitute more than this amount, they shouldn’t be less except when you’re building or replenishing the account.) Once your working capital and endowment accounts exceed several thousand dollars, your organization can consider professional money management of such assets without sacrificing liquidity.
Look for a Registered Investment Advisor (RIA). Investopedia.com defines an RIA as “an advisor or firm engaged in the investment advisory business and registered either with the Securities and Exchange Commission (SEC) or state securities authorities.” An RIA has “a fiduciary duty to his or her clients, … a fundamental obligation to provide suitable investment advice and always act in the clients’ best interests.”
The more than 34,000 RIAs in the United States range from single-advisor firms registered in one state to large, SEC-registered companies (either independent or affiliated with wirehouses, insurance companies, or mutual funds) with billions or trillions of dollars under management. Of this vast RIA universe, a small minority offers established strategic and tactical strategies for accounts as small as $15,000. I know of one that will actively manage accounts as low as $2,000. Advances in trading technology and innovations in the investment products RIAs use (e.g., exchange-traded funds) made such small accounts cost-effective.
As a result, nonprofits have more access to bona fide professional management of endowments and cash reserve funds than ever before, with fully liquid strategies ranging from very conservative to the opposite end of the risk spectrum. Even small to medium-sized organizations can now either create a diverse portfolio of strategies or stick with low-risk options that historically decrease inflation risk. This is something that federally guaranteed depository accounts largely fail to do. If your nonprofit seldom needs to access its cash reserves, investing some of that money outside of depository institutions is a smart move.
Don’t misunderstand me. There’s nothing wrong with a bank account, provided that assets invested in them are short-term in nature and well suited to the few risks inherent in such accounts, primarily inflationary and interest-rate risks. If your organization has (or establishes) a cash reserve that struggles to maintain a stable balance that exceeds an RIA’s minimum account size, bank or credit union accounts are the better choice. If, however, your board or investment committee has no stomach for slightly elevated investment risk, keep your money in the bank until you educate those members on the investment risk they’re already taking as fiduciaries by keeping endowment assets and cash in a depository institution.
Step 5: Incorporate cash-reserve and endowment components into capital campaigns and regular fundraising efforts; tout those accounts to grantmakers
Mark Vincent’s fifth question concerns what nonprofits communicate to their donors and grantmakers. Does money simply enable your organization to survive? Are you being frugal with what little you have? Or do you plan to expand your efforts with the next round of contributions? This question resonates strongly with what David Beckwith advised at the Clinton School of Public Service:
- approach current and potential donors not with a narrative of weakness, but one of growth, strength, and greatness of mission
- negotiate with grantmakers as an equal, not a supplicant
- emphasize the good that donors’ gifts can support, the positive difference their money can make, not your need for funds.
This kind of emphasis combined with wise money management enables you to show, as Marc Koenig writes, that a donor’s gift “creates more value with you than it would if it were given elsewhere, lingered in their bank account or was spent on a delicious latte.” Your nonprofit can talk to grantmakers and donors about “creating something of value, … changing lives and creating impact,” thereby making “the world a better, more astonishing place to live.”
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