I’ve often argued that the traditional non-profit model discourages necessary risk-taking.  It does this for a few reasons:

1) Employees can’t own stock, so they don’t benefit from financial success.  Yet they’re still vulnerable to financial failures (i.e. they can lose their jobs or suffer career setbacks).  To a lesser extent, the same is true for non-profit Board members.  When someone’s got no stake in the upside but is still exposed on the downside, the rational response is extreme conservatism.

2) The culture of the non-profit sector is such that managers go to absurd, herculean efforts to avoid admitting failure, mostly in an effort not to embarrass themselves in front of funders.

3) Non-profit organizations are chronically under-capitalized.  By failing to build reserves or hoard surpluses, we end up in a situation where each budget is a tightrope.  A single serious misstep is enough to pose an existential threat to the organization.

So, if the non-profit sector is going to get more comfortable with risk, it needs to start acting more like the for-profit sector, right?  It’s true that for-profit businesses rarely experience any of these problems.  Unfortunately, they tend to swing too far in the exact opposite direction.

Unless you’ve been living in a cave (yes, your art studio counts), you’re aware of what’s going on with the financial markets.  Huge, venerable institutions are collapsing (Lehman Brothers), teetering on the brink getting bailed out by taxpayers (AIG), or being sold for a fraction of their recent valuations (Merrill Lynch).  A significant contributing factor to this mess is the fact that free-market capitalism - for which I am generally a sincere cheerleader - actually encourages excessive risk-taking.  The reasons for this are a mirror image of those I listed above:

1) Companies “incentivize” their employees by granting stock options.  The nature of an options contract is that it magnifies the gains from a stock’s upward movement but becomes worthless long before the stock itself does.  Here’s how it works:

Let’s say your company’s stock is at 100 and you’ve got an option to buy stock at 105.  Until that stock reaches 105, your option isn’t worth much.  When the stock hits 106, it’s worth roughly $1/share.  At 115, it’s worth $10/share.  Etc.  Now, imagine you’ve got to choose whether or not to take on a risky project with a 50/50 chance of success.  If it succeeds, your company’s stock will go to 110.  If it fails, your company’s stock will go to 60.  If you’re a shareholder, this is a terrible deal: heads you win $10, tails you lose $40.  But for the employee holding the options contract, it’s a golden opportunity: heads you win $5, tails you lose $0.

This is obviously a greatly simplified example, but you get the point.  Options grants encourage employees to take big risks that aren’t necessarily in the best interests of the company’s shareholders.

2) Executives of publicly traded companies are equally eager to avoid admitting failure, but it has the opposite effect as in the non-profit sector.  For a publicly traded company, the critical time not to screw up is in your quarterly earnings report.  Wall St. is ruthlessly impatient.  The markets rarely are willing to wait for long-term investments to pay off.  Rather, they focus almost exclusively on a) earnings per share in the last three months and b) predicted earnings per share in the next three months.  Miss your estimate and your stock price gets clobbered.  Beat your estimate and it soars.  This pressurized environment acts as an amplifier for the misaligned incentives in point #1.

3) The sophisticated capital markets that large corporations can access mean that companies can tap essentially unlimited resources.  This was a huge part of the problems we’re seeing in the current crisis.  Companies like Lehman and Merrill were leveraged up the wazoo, effectively investing $30-40 of borrowed money for each $1 of collateral assets.  As long as those investments keep going up, profits are multiplied many times over.  But as soon as they start to fall, the proverbial house of cards collapses.  Under-capitalization is obviously a factor here, but in a very different form than afflicts the non-profit sector.

In both cases, the essential dysfunction comes down to what’s known as the “agency problem“. The term refers to a category of conflicts of interest that arise between management and other stakeholders.  These conflicts most often occur when incentives are misaligned or when management has access to information that isn’t available to shareholders, Board members, creditors, etc.

The main mechanism for addressing these problems in the for-profit world is government regulation.  We’re going to hear a lot about this over the coming weeks, as the feds debate what kinds of new rules need to be imposed on Wall Street.  In theory, such regulations are designed to mitigate the agency problem and protect shareholders, customers, etc. from excessive risk.

There’s no such easy solution on the non-profit side.  You can’t force non-profit managers to acquire stiffer backbones by government fiat.  However, you can tap into our tendency to dance shamelessly to the tune of our funders.  Any meaningful shift in the non-profit sector’s culture of risk must therefore begin with a shift in strategy from our leading philanthropists.

I was at an event a few years ago with a bunch of peers from the arts service community, including Ben Cameron, who was then head of Theatre Communications Group but is now the Program Director for the Arts at the Doris Duke Charitable Foundation.  Ben observed that, for the most part, arts funders were acting like consumers rather than investors.  His point was that most funders focused on short-term, narrowly defined, project-based support, instead of identifying important organizations doing exciting work and providing the financial resources for them to leverage their native strengths over the long-term.

If our biggest foundations could break the habit of cautiously supporting tiny, specific aspects of an organization’s activities and begin ensuring sufficient capitalization and providing multi-year general operating support, we’d go a long way towards fixing at least 2 of the problems I identified at the beginning of this post.  (The good news is that I’m starting to see a few moves in this direction, but that’s a subject for another post…)

The issue of incentivizing employees and Board members by ensuring that they benefit when the organization thrives is a lot trickier.  IRS rules prevent “private inurement” from contributions given to a 501(c)(3), so any kind of explicit sharing of a revenue surplus would be illegal.  At Fractured Atlas we’ve tried to work around that limitation by awarding annual performance-based group bonuses that, while meager by Wall Street standards, are meatier than at any other small non-profit I know.

Bonuses help, but they’re not a panacea.  That’s partly because non-profit employees tend to be motivated by largely non-financial factors (e.g. belief in the organization’s mission, aesthetic appreciation of its work, etc.).  Harnessing those passions in a way that encourages responsible risk-taking is difficult but potentially powerful.

Measurement is one tool.  To the extent that you can quantify “mission return on investment” (whatever that means) and make that transparent throughout the organization, people become more likely to appreciate the “upside” of a given project or decision.

Culture remains the most important factor, though.  We need to constantly remind each other that it’s okay to fail.  In fact, if you’ve never suffered a complete, humiliating, public failure, then you’re probably not trying hard enough.  Time to grow some cojones and take a chance.

Novelist Tao Lin has invented a provocative new way for artists to sell out.

I am offering 60% of the U.S. royalties of my second novel to “the public”.

I am selling 6 shares (of 10% of the U.S. royalties of my second novel) for $2000 per share.

For each share you own you will receive 10% of the U.S. royalties of my second novel.

This includes all U.S. serial, reprint, textbook, and film (and other performance) royalties.

Shareholders will receive checks (and copies of the royalty statement from my publisher) in the mail every 6 months after the book’s publication (probably Fall, 2009 or Spring 2010). Shares can be resold at any price at any time, I will facilitate trading and promote it on my blog if that is what a shareholder wants. I accept Paypal.

Apparently he’s sold all but one of the shares so far.  He’s managed to get a $12,000 advance on his next book without even having to pitch a publisher.  He’ll also have some folks out there pimping the book when it does come out, since they’ll have a financial incentive to do so.  I don’t know how many artists would be clever (or ballsy) enough to try this, but I hope this isn’t the last time we see someone attempt this model.  Financial risk and uncertainty is a huge problem for artists, and this amounts to a hedging mechanism.

WNYC recently broadcast a segment that touched on the “grey-ing” of the non-profit arts sector. It’s a familiar subject that most artists have heard plenty about: The audience for the arts is gradually getting older and unless an effort is made to engage a younger demographic, many art institutions will die with its patrons.

But this debate focuses specifically around arts leadership: Are seasoned veterans more equipped to run arts institutions than younger administrators with new (and potentially controversial) ideas? What can the arts industry do to cultivate younger leaders and what is their place in the institutions’ future.

Here’s the summary of the debate from their website:

If it’s too loud, you’re too old. That’s the old rock ‘n’ roll saying. But many believe veteran experience counts in running arts organizations. Others say fresh blood is needed at a time when the arts need to reach younger audiences. In this week’s “Soundcheck Smackdown,” Lee Rosenbaum, a veteran cultural journalist who blogs for Artsjournal.com; and Barry Hessenius, author of the study “Involving Youth in Nonprofit Arts Organizations,” square off on the topic.

Listen to the full audio here.

The Community Arts Network is publishing a series of “bridge conversations”:

“Bridge Conversations: People Who Live and Work in Multiple Worlds,” [is] a series of 18 conversations commissioned by the Center for Civic Participation’s Arts & Democracy Project and the Community Arts Network. These conversations highlight a diverse group of people — including artists, community activists, educators, funders, political leaders and scholars — who are building bridges and creating hybrid and integrated programs, strategies and lives. They illustrate how some of the most creative strategies for positive social change live in the intersections of disciplines, sectors, cultures and generations.

I was invited to interview Ruby Lerner from Creative Capital.

Philanthropy.com reports on a proposal for a new kind of for-profit / non-profit hybrid entity: the L3C:

[T]he low-profit, limited liability company, or L3C is designed to increase the number of program-related investments, or PRI’s, that foundations make in social-purpose businesses by making those enterprises easier to find. Proponents hope that foundation investment in those ventures would, in turn, would spur an influx of private capital.

For those of you who aren’t tax lawyers, the key issue here is that private foundations are required by law to distribute at least 5% of their assets annually. The vast majority of the time this is done exclusively through grants to public charities. However a little-used option exists whereby foundations can make program-related investments - investments that they expect to make a return on - which count towards the 5% threshold. The L3C is designed to promote and facilitate this process.

Americans for Community Development, the organization which is most actively promoting the L3C concept, has a great F.A.Q. that explains the concept in greater depth and provides some down-to-earth examples.

The line between for-profit and non-profit enterprise has been getting blurrier and blurrier. Increasingly we’re seeing charities graded by independent agencies on their financial performance and efficiency as if they were stocks to invest in. At the same time, for-profit corporations are under mounting pressure to exercise “corporate social responsibility” and soften the ruthless pursuit of profits with concern for the greater social good. It seems to me that the L3C is a logical and welcome next step.

This morning I heard on the radio about a new art group in San Francisco with a radical business model: selling “subscriptions” to new works by contemporary artists. From their website:

THE THING is an object based quarterly publication. Each issue of THE THING is conceived of by an individual artist, reproduced and wrapped by the editors (Jonn Hershend and Will Rogan) and sent to the subscribers.

Apparently they’ve got around 850 subscribers around the world who pay $120/year for a subscription, which is impressive considering they’ve only actually produced one “issue” so far. For subscribers, it’s an opportunity to get 4 new works from contemporary artists each year for $30 per piece.

I’ll be interested to see how this plays out. My hunch is that there’s a viable, creative new business model here, but a lot depends on the group’s ability to manage their own growth. Under the current approach, the larger the subscriber base grows, the less valuable each issue becomes (since each object is less rare). There are ways around that challenge (e.g. have the artists produce variations, recruit multiple artists per issue, etc.) but it’s tricky regardless. Either way, probably worth keeping an eye on.