The Financial Times reports on the increasing number of MBAs working in the non-profit sector:

In the past, executives seeking qualifications that would help them in the non-profit sector headed to policy schools or took programmes in education or non-profit management. “Now a lot more people are going the MBA route,” says Mel Ochoa, who graduated from the NYU Stern MBA programme in May and heads the marketing department of Achievement First, a charter school organisation in Connecticut and Brooklyn.

Mr Ochoa says this is because of the new requirements of non-profit organisations. “They’re changing their attitude towards the people they want on staff,” he says. “They want a lot of the skills you learn in business school, such as strategy and finance – and they want those applied to their non-profits.”

Full disclosure: I got my MBA from New York University’s part-time program, which I attended over a long 4 years while working at Fractured Atlas.  It was an incredibly valuable experience, and I use what I learned there every day.  I also recruited the Chairman of our Board of Directors from the ranks of my professors.

That training has undoubtedly helped me build and run Fractured Atlas in a way that’s atypical for the non-profit sector, and that often resembles a for-profit enterprise.  And, of course, most of our programs and services are, in turn, designed to help our members function more effectively as businesses.

These days, however, there’s some controversy in the non-profit sector over whether “acting like a business” is something we should be striving for or not.  For ages the mantra was that not-for-profit organizations needed to be “more businesslike” to increase their efficiency and effectiveness.  But in recent years there’s been a backlash against this notion, as chronicled by everyone from Don’t Tell the Donor, to Grantmakers in the Arts, to (sort of) Andrew Taylor.

To some critics, “acting like a business” conjures images of Enron, Halliburton, and perhaps now IndyMac or Countrywide.  Greed.  Excess.  Fiscal recklessness.  Lack of accountability.  I’d argue, however, that guys like Ken Lay and Angelo Mozillo aren’t acting very businesslike.  They’re acting like crony capitalists or even two-bit thugs.  And, to its credit, the capitalist marketplace eventually punishes such bad actors, albeit often after they’ve done a lot of harm.

So what does it look like when someone is acting businesslike?  I believe it comes down to a few key factors:

1. Pick the right customer (and know who your real customer is)
2. Make decisions based on unsentimental, dispassionate analysis
3. Seek to build long-term value

Perhaps this is too reductionist and I’m sure I could refine or supplement these criteria if I gave it some more thought, but I’m satisfied that this is a decent starting point.  The good news is that any of these principles can be applied by any business - for-profit or not-for-profit, international conglomerate or self-employed dancer.  Taking this view not only doesn’t reduce a non-profit organization’s mission orientation, but can actually enhance its clarity of focus and capacity for action.

Let’s look at each factor and I’ll try to offer some insights into how a B-school schlub like me thinks about this stuff.

Picking the right customer and knowing who your real customer is

Any business has customers.  They’re (duh) the people who buy what you’re selling.  If you don’t have a customer, you don’t have a business.  If you can match the right product or service with the right customer, then you’ve got a great business.  Simple, right?

For most for-profit businesses this is very straightforward.  A widget-maker seeks out people who need widgets and tries to offer them at a price that is a) higher than the costs of production and distribution, and b) lower than the perceived value they will provide to the widget-needing-individual.  That sweet spot is the basis for any economic transaction.

Where this gets tricky is when the one paying for the widget isn’t the same one consuming the widget.  Consider the US health insurance system.  The patient consumes the service but the insurance company pays for it.  Doctors, therefore, provide services based on what the insurance company will pay for, rather than what the patient needs.  That’s because our inevitable tendency is to focus on the payer rather than the consumer.  This is a self-preservation instinct, since a business can’t exist without money to fund its activities.

Of course, this payer-consumer disconnect happens all the time in the non-profit world.  Traditionally, non-profits have gotten most of their funding from individual donors and/or institutional funders.  Those people are very rarely the ones being served by the non-profit’s work.  So how does the non-profit ensure that its focus remains on the constituency it’s supposed to serve, where it surely belongs?  Unfortunately, it often doesn’t.  Whether they admit it or not, the “real customers” that such organizations focus on are all too often the donors or funders who underwrite their operations.  Fulfilling a mission - creating great theatre, feeding the homeless, curing malaria - becomes a tactic for pursuing the true goal (at least subconsciously) of satisfying the people who write the checks.  As you can imagine, all sorts of dysfunctional crap comes out of organizations that fall into this trap.

So how does a non-profit keep itself pure and focused on the people who need its help?  I’d argue that, whenever possible, it should strive to align the funders and consumers of its programs.  The simplest way to accomplish that is by adopting an earned revenue model.  Fractured Atlas has a rule that we don’t start new programs or services unless they can be fundamentally self-sustaining based on earned revenue.  By relying on membership dues and program fees, we’re guaranteed instant (and potentially painful) feedback on whether our services are actually meeting the needs of the artists and arts organizations we serve.

But this doesn’t always work, because there are some mission-essential activities which are impossible to monetize through earned revenue.  For Fractured Atlas, this includes our advocacy work.  A homeless shelter or animal welfare group, meanwhile, would find it difficult or impossible directly to monetize any of their programs at all.  So does that mean we all need to steer clear of these activities and only do things where we can make a buck?  Of course not.  But it does mean that we need to be more cautious and intentional about aligning the interests and perspectives of our funders and consumers.

There are a couple of ways you can do that.  At Fractured Atlas we often conceptualize these situations as investments, the same way a for-profit might spend money on marketing or research and development.  You don’t expect to get anything back directly, but you do expect a positive return in the long-term through indirect channels.  A project like Place + Displaced provides us with an unprecedented depth of information about the way artists live and work in their communities, along with new insights into the challenges they face every day.  I don’t believe it dimishes the intrinsic mission-value of the project to say that it serves a secondary function of providing great market research into how we can better serve our constituency.

That kind of R&D / marketing model is a nice framework for artists and arts organizations.  It’s vital to be able to pursue creative or audience development opportunities even if they’re not readily grant-fundable.  (I’ll address this concept again when I talk about building long-term value.)

So what if there’s really just no way to monitize an important program through earned revenue, either in the short or long term?  Well, then you need to rely on contributed revenue and you’re stuck with separate funders and consumers of your service.  There are still practical steps you can take to ensure this doesn’t result in mission drift:

1. Strive for autonomous program design by program staff (e.g., an artistic director or a program officer).  The front-line personnel at a non-profit are often better connected to the work it does or the people it serves than are the executives, whose focus by necessity is on the bottom line.
2. When possible, develop explicit, quantifiable criteria for program success and share them with the program’s funders/donors.  That way everyone’s on the same page about what you’re trying to accomplish.
3. Be as transparent as possible with both your constituency and your financial supporters.  It’ll help keep you honest and mitigate anyone’s concerns that their needs aren’t being considered.

Making decisions based on dispassionate, unsentimental analysis

I mentioned above that I use what I learned in business school every day.  That’s true, but the actual tools, concepts, and models that I learned weren’t the most valuable part of that experience.  The truly useful part was the simple exercise of thinking, talking, and writing about businessy problems in a rigorous manner three times a week for four years.  Before that my decision making was driven by instinct and emotion.  Today, instinct and emotion still play a part, but they’re balanced by a practiced ability to be coolly rational and unsentimental about organizational problems.

When people say “business is business” they’re talking about this kind of cool, impersonal attitude.  Usually there’s also an implied profit motive, but there doesn’t have to be.  You can be just as dispassionate about humanistic concerns.  The key is to apply an analytical framework or toolset that helps prevent biases (even unconscious ones) from clouding your perspective.

For financial analysis, my favorite tool is net present value calculation.  This tool from corporate finance is used to assign a risk-adjusted value in today’s dollars of a series of future cash flows.  It’s an excellent framework for assessing the long-term financial implications of a proposed project, or for comparing multiple competing projects to see which makes the most financial sense.  The non-profit arts sector is notorious for boondoggle capital projects that destabilize or even destroy otherwise great organizations.  The managers responsible for these quixotic messes may be relying on the generosity of donors or funders to bail them out when this happens.  But how much better it would be for the sector as a whole if we could get into the habit of making better decisions in the first place!

The inverse of this is the tendency of non-profits not to invest funds in a speculative project unless they can pass the expenses off to a third-party funder.  I was in a meeting not long ago in which we discussed a potential project that would cost roughly $100,000 to carry out, but which didn’t have any good funding prospects.  Conservative back of the envelope calculations suggested that doing the project might result in $120,000/year of earned revenue, more or less in perpetuity, without any additional costs.  Even assuming a high level of risk, that cash flow stream is worth perhaps $500,000 in present value terms.  In other words, deciding to undertake this project would be like trading $100,000 for $500,000.  Kind of no-brainer, huh?

But $100,000 is a lot of money for a small organization like Fractured Atlas, and the prospect of spending our own money in that way was pretty scary for most of the folks in the room.  The abstract fear associated with writing a six-digit check without any outside party taking the risk was overwhelming the logical appeal of the undertaking.  Non-profits, especially small ones, fall into this trap all the time.  In the long-run, being irrationally conservative is just as deadly as charging headlong into an ill-advised capital project.  Not to take on the above project would be like turning down a no-strings-attached donation of $400,000 which could be used to support or expand any of our programs and services.

I believe there’s an appropriate analytical framework for almost any category of organizational decision making.  They needn’t all come from fancy-pants financial models either.  Sometimes what you need is an ad hoc model based on your own internal, mission-based logic.

Permit me another example from Fractured Atlas.  We’re an unusually broad-based arts service organization.  Most of our peers focus on either a specific geographic region, a particular artistic discipline, or a narrow category of service.  By contrast, we’re national, multi-disciplinary, and customer-centric (i.e. rather than program or mission-centric).  That’s dangerous, because it imposes no discipline or boundaries in the program-development process.  And frankly I’m a lousy leader for such an organization, because my own instinct is always to try to do anything and everything under the sun.

Over the years we’ve developed an internal decision-tree to address this issue.  When an opportunity crops up for a new program or the expansion of an existing service, we ask a few key questions to assess whether it’s something we should do:

1. Can it be delivered nationally or is it limited by geography?
2. Is it relevant to artists from many different disciplines?
3. Is it scalable enough to reach a large audience?
4. Is anyone else in the field doing this?  If so, is there reason to believe our approach will be significantly superior/different to justify the redundancy?
5. Do we have (or can we acquire) the capacity and know how to do the work in a super high quality way?

Generally speaking, if the answer to any of those questions is “No” then we don’t do it.  When we first started using this tool, we actually cut out about half of the programs and services we were offering at the time, since they didn’t meet our criteria.  We got some complaints from our members, but we became a much more focused, “lean-and-mean” organization.  And it turned out that cutting the fat actually helped position us for a period of explosive growth over the ensuing years.

Building long-term value

Perhaps surprisingly, non-profits are often better at building long-term value than for-profits, especially publicly traded companies.  The stock market is obsessed with quarterly earnings reports and publicly traded companies are obsessed with their stock prices.  Lots of stupid decisions have been made because of those misguided short-term incentives.  But non-profits don’t have stock, which should free us up to worry about the long-term, right?  Sometimes it does indeed work that way, though not as often as it should.

Let’s consider three common traps:

Trap #1: Fear of investing in revenue-positive, mission-relevant opportunities if they can’t be funded by contributed income.

I’ve already talked about this one a little bit so I won’t belabor the point.  But this is a major pet peeve of mine so I’m having a hard time dropping the issue entirely.  I’ve had countless conversations with my counterparts at other arts service organizations in which I’ve proposed some kind of joint project.  Even when I can demonstrate the compelling positive financial return from the undertaking, I am, more often than not, met with an unwillingness to proceed unless I can bring grant funding to the table that covers their initial costs.  When that third party funder fails to materialize, we effectively flush lots of potential long-term value down the proverbial toilet.  It’s a terrible cliche, but sometimes you really do have to “spend money to make money”.

Trap #2: The superficial allure of a balanced budget.

The conventional wisdom is that non-profits should have balanced budgets.  That means they should plan for revenue and expenses to be as nearly equal as possible over the course of a fiscal year.  The ostensible reasoning here is that non-profits are mission-based, not profit-based.  A surplus would indicate that grant funds aren’t being fully spent or that program fees have been set higher than they should be.  A deficit would suggest poor financial planning and possible organizational instability.

The conventional wisdom couldn’t be more wrong, and it’s a shame that so many non-profit leaders (and worse, their funders) take this view.  I don’t think I can say it any better than non-profit consultant Jeanne Bell:

A potentially harmful habit practiced in many community nonprofits is presuming that a break-even budget is mandatory. Board members and staff may be under the influence of the false but persistent ‘nonprofits can’t make money’ myth as they develop the year’s income and expense plan…. Instead of “How can we make the budget balance?” the annual budgeting cycle should begin with the question, “What financial outcome does our organization want or need this year?” Different scenarios lead to different decisions about what the budget’s bottom line should look like:

1. We need to increase reserves or pay down debt: adopting a surplus budget. When the organization’s leaders decide that its cash and other reserves are lower than ideal, the organization can plan to generate more income than expenses, creating surplus funds that can be used in future years. A surplus may also be needed to provide funds for paying down debt or for easing cash flow….

2. We can’t gain ground now, but we can’t lose ground either: the break-even budget. Typically, organizations choose break-even budgets by default and the skin of their teeth. A first cut on the budget shows expenses much higher than revenue, so the staff then tries to figure out how to increase the revenue number (but still stay close to reality) and decrease the expenses (but not damage programs). The staff and the Finance Committee tack their way towards a break-even budget, and hope that their cautiously optimistic projections work out.

3. A…reason for a deficit budget is a decision to invest. For example, the organization may invest funds in strengthening its fundraising capacity, or in new programming. Leadership believes that resources from previous surplus years can be risked as investments in future programmatic or financial paybacks.

At Fractured Atlas we’ve had a couple of break-even budgets over the years, but most have projected either a surplus or a deficit.  In my experience these things are cyclical, especially for a growing organization.  When ramping up for a major expansion, we run a deficit as we make investments in infrastructure and capacity to fuel that growth.  As the expansion unfolds and those investments pay off, we shift to a surplus.  Sooner or later, it’s time for another ramp up.

It’s a bit of a rollercoaster, and I know for a fact that it makes some of our funders (and even some of our Board members) uncomfortable.  But this model has helped us create enormous long-term value.  Ten years ago our annual budget was $7,500.  Five years ago it was $100,000.  Today it is $4.2 million.  You can’t grow like that unless you invest in your own organization, and that means deficits.  Likewise, surpluses are how you build reserves to invest in future growth.

Trap #3:Treating funders like investors (the wrong kind, that is)

We’re often told to think of funders as the non-profit equivalent of investors.  It’s not a bad analogy.  Like investors, funders finance your activities and measure the return on that investment.  The return is in mission fulfillment, not financial gain, but it’s the same basic relationship.  And just as a dissatisfied investor will sell his stock, so a dissatisfied funder may pull her support.

Believe it or not, it’s actually a good thing when funders don’t simply write a check and say “have fun, see ya’ later!”  When a funder takes a serious interest in your work, enough to pay close attention to the results you’re getting and the progress you’re making, then that makes him a potentially invaluable partner.  Such allies provide money, yes, but they can also provide advice, connections, and other intangible resources.

But the kind of interest they take - the type of investor they resemble - is very important.

I mentioned before that the stock market is notoriously obsessed with quarterly earnings reports.  There are many reasons for that, but in part it’s because most shareholders aren’t really interested in the underlying business of the companies they invest in.  They need a very simple proxy for a company’s financial health and the quarterly earnings per share figure is the best they can find.  If it’s lower than they’d hoped, they sell the stock.  If it’s higher, perhaps they’ll buy more.

Because they live and die by their quarterly earnings, publicly traded companies make enormous efforts to “manage” those earnings.  Transactions might be timed specifically so that they fall into one quarter or another.  Accounting tricks are used to hide losses and exaggerate gains.

Many non-profits resort to similar shenanigans in an attempt to impress their financial supporters.  They bend over backwards to put a positive spin on program performance, sometimes to the point of de facto dishonesty.  Likewise, these organizations go to great lengths to hide their failures and shortfalls.

Then there’s private equity.  Private equity funds invest in non-public companies precisely because those companies don’t have to report their earnings quarterly and are therefore able to focus on long-term profit over short-term gains.  Private equity investors get to know the company’s management and study its business in depth.

Non-profits should cultivate “private equity-like” relationships with funders rather than relationships that resemble market investments.  Resist the temptation to keep your funders at arms-length and shield them from the ugly complexities of your operations.  Be honest and transparent about your failures as well as your successes.  Make sincere efforts to reveal and explain your organization’s internal logic.

Not all institutional funders or private donors want this kind of relationship, of course, but many do.  And keep in mind that I’m not for a minute suggesting that funders should be allowed to micromanage your program operations or policies.  The goal is for them to have a deep and accurate understanding of who you are and what you do, so that they’re in the best possible position to help you grow and develop as an organization.  Because that’s a great way to build long-term value and a strong organization.

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 piece originally appeared as an article in the Fractured Atlas newsletter on April 15, 2004.

This art stuff is a tough racket. High-profile success stories aside, non-commercial creative enterprises operate in the red. Brutal cash-flow cycles, limited financing options, and competition from mass market media combine to paint a grim portrait of the economic lives of artists.

Traditionally we’ve made up the shortfall with charitable support. Over the past century, a delicate economic ecosystem evolved to keep artists in business, with a donor-friendly tax code and a tradition of patronage each helping to fill the funding gap.

Today the landscape is changing. The estate tax has been repealed, dramatically reducing incentives for wealthy Americans to form new foundations. New rules on corporate governance, designed to combat corruption, threaten the survivability of small family foundations. And the old culture of patronage - source of sugar daddies like the de Medicis and Peggy Guggenheim who respected the need to nurture artistic talent over time - is being replaced by a relentless focus on instant results and rapid growth.

In this uncertain funding environment, artists are fighting harder for fewer dollars. It’s a faster, tougher world, and the time has come for new ideas that address these emerging economic realities.

Enter “social entrepreneurship”. In the last decade it’s been a hot topic in business and philanthropic circles alike. The idea, in a nutshell, is that non-profit charitable missions can be better funded and even better fulfilled by adopting “for profit” business ideas. Non-profits that embrace this concept support themselves, entirely or as part of a diverse funding plan, on their own earned income, such as urban health clinics that fund outreach programs by contracting their services to major hospitals. Foundations, likewise, are beginning to view their activities as a kind of social venture capitalism, recognizing that what business entrepreneurs are to economic innovation, they can be to social change.

Although these ideas have been in vogue for a number of years, they remain largely overlooked by the arts community. Nonetheless, the time has come to consider how we can become less dependent on regular handouts and more innovative in safeguarding our financial futures.

The first step is to figure out what makes you exceptional and explore how it can be sold in a larger marketplace. This already happens, albeit modestly, every December when ballet companies and regional theatres abandon their usual artistic guidelines to perform the Nutcracker and A Christmas Carol. Such moves may seem cynical or compromising, but the simple fact is they pack houses and in turn support the next year of adventurous programming.

But these examples only scratch the surface of what’s possible. Many arts organizations have just begun to consider what role they might play in education, for example. Who better to teach art in public schools than an emerging painter making waves in the downtown scene? Big-name institutions might even explore the idea of brand extensions, in which a strong brand is attached to unrelated products as a way of capitalizing on consumer impressions. (Think: “The Apartments at Lincoln Center” or a chain of “Cafe MOMAs”) At Fractured Atlas, we developed expertise in areas like health insurance and internet applications. When the large potential market for those skills became clear, we spun off a for-profit subsidiary to exploit the opportunity. That company now operates independently and uses its profits to subsidize Fractured Atlas’s charitable activities. Approaches like this are certainly not without risks, both financially and from a credibility standpoint. But there are also huge potential gains for the bold and creative.

Funding agencies can get in on the act as well by encouraging entrepreneurship and self-sufficiency and by supporting groups that act to secure their own financial futures. It’s also time to look beyond traditional grant models and consider ways to provide investment capital, seed funding, and development loans.

For an industry whose very existence is based on pushing society’s envelope, we in the arts can be terrified of changing how we do things ourselves. The world around us is evolving, and if we can’t keep up then the future holds only further marginalization.