Warning Signs — Preparing for the Crash of the Herd and Funding Crisis
The Foraker Group has been busy over the past months working with organizations in crisis. Most had been strong nonprofits – all were providing services important to a large number of constituents. Now, they needed help. Unfortunately, they are not alone.
Three years ago the last Foraker nonprofit economic study identified trends the sector could expect in the near future. From the data we found that probably too many nonprofits existed in Alaska. As a result, we predicted “the crash of the herd.” And because of shifting government funding priorities, we predicted a “funding crisis” was on the horizon. To refresh memories, here were our assumptions.
Crash of the Herd
The study showed there were 7,000 nonprofits in Alaska in 2010. Of these, 4,800 were charitable nonprofits and of those, 1,100 had staff. It was not conceivable to us how that number could be sustainable based on the following reasons.
Nonprofits must have boards. In Alaska the normal size of a board is somewhere between 9 and 15 directors, but the minimum number required in Alaska is three. The logic that leads to our belief that we have too many nonprofits starts with the fact that we have 100 people for every nonprofit – twice the national norm. Of those, only 72 are 18 years old, and therefore legally able to serve on a board. It is fair to assume that not every adult is willing to serve on a board. However, an accurate indicator to identify those most willing to serve is their voting habit. Individuals who vote in general elections are more likely to serve on boards. That reality lowers the prospect pool to about 32 candidates for every board. But not all are good candidates. While there have always been a few young adults willing to serve on boards, most are too busy until their mid-30s establishing their lives, building their families and establishing their careers. And while some people will serve on boards after retirement, many over 65 are less willing because of changes in their routine. Based on this information, we estimated that at best, there is a pool of about 22 candidates to fill every 15 seats on a board. One of the most common questions we get at Foraker is, “How do we find and recruit, and then keep, board members?”
However, the crash does not end with a scarcity of board members – all industries expect a workforce shortage because of the retiring baby boomers. Since our sector does not pay as well nor offer competitive benefits, that shortage will be more extreme for nonprofits. Last month’s newsletter referred to a recent study done by CompassPoint, Under Developed, that describes the nationwide shortage of skilled development directors. Bridgespan did a study in 1996 that predicted an eventual shortage for all skilled nonprofit professionals, especially CEOs. They predicted that shortage would continue until at least 2020. Recent experience at Foraker tells us that too few qualified people are available who want to take on these jobs today. Many of the leadership positions on our website are open for months before they are filled. The crash has begun.
Nationally, nonprofits receive 32% of their income from government – in Alaska, it’s closer to 60%. Therefore, the inevitable cutbacks in federal funding will have a disproportionately negative impact here. The state is also re-thinking its funding priorities. Most Alaskans are unaware that 93% of our state’s budget is paid by one industry, oil and gas. Any downturn in value or production will have an immediate impact on our state’s capacity to continue funding at recently expected levels. Those who were in the state in the mid-1980s remember the economic downturn when oil prices fell to record lows. The fact is that oil production is declining and will continue to do so – there is consensus on that point. The business environment for the oil and gas industry to invest in the state will dictate how long their investments and that income will continue.
Our sector’s leaders need to be clear on a few facts. One is that eventually the state’s revenue from oil and gas production will not be able to pay 93% of the state’s budget. So who will? That’s a big question. While other major taxable industries like fishing, hard-rock mining, and tourism are among the largest nationwide, they alone will not be able to make up the difference. Last year ISER (Institute for Social and Economic Research at UAA) published a report stating that even if politicians garner the political will to use the interest from the Alaska Permanent Fund for services 20-30 years out (the original intent), it will not be enough based on current levels to make up the difference from the loss of oil revenue. That leaves few options to consider – like reinstating the personal income tax or hoping for some new windfall. According to ISER, even with either of those outcomes, we will still have a very tight budget. (Since it seems many Alaskans, even over the age of 8, still believe in Santa Claus, there’s nothing to worry about.)
It would seem that nonprofits should encourage lawmakers to maximize the length of time we have to prepare for the inevitable future. We need a long-term fiscal plan. We need continued production from the oil and gas industry and we need to start the dialog now about the other options. Our sector’s capacity to provide the needed level of service depends on all of us becoming more engaged in public policy. If you are not informed, we urge you to dig deeper. Your organization’s future depends on your understanding and leadership.
But we are charities – right? Can’t we depend on charitable giving to make up the difference? The problem with that notion is that charitable support represents less than 20% of our collective income. It is important, but we can’t expect that it will make up for the potential loss of government funding. The latest Giving USA report found the total amount given in 2012 was $316 billion. Foundations gave 14.5% of that amount, corporations 5.5%, and individuals the rest through annual gifts or bequests. In Alaska the oil and gas industry alone gave over 11.5% — over twice the norm for corporate giving nationwide. Any change in that industry’s generosity will only increase the funding crisis, especially for arts and education nonprofits that have traditionally received significant support from that source.
We are blessed to have extremely generous foundations, both in and out of the state, that provide a disproportionate level of funding to Alaska’s nonprofits. Rasmuson Foundation alone almost matches the national norm for all foundations. Of all the funding sources, we think foundation support should be more stable, unless there is another stock market crash. Unfortunately, most foundations do not fund ongoing operations. The funding crisis will come from the lack of ongoing, operational funding.
The predicted funding crisis is magnified by the lack of other sustainable revenue, specifically earned revenue that generates a profit and individual charitable giving. Do you have a strategy to earn revenue where appropriate? Does it provide a “profit?” Or, have you begun to engage in fund development from individuals? If you are just now starting and already experiencing the funding crisis, you are too late. The funding crisis has many causes. Today it is in full-force. It will get worse before it gets better.
We discover at least one new nonprofit in crisis every week. Some have determined their only option is to go out of business. Many are making significant cuts to services. Others are merging. If they waited until now to respond to the changes in the environment, unfortunately there are few choices.
The predicted trends are real and are here. Based on what we have learned from the first organizations we’ve assisted in crisis, here are the top ten warning signs that were consistent in what we’ve seen so far.
- The board was not engaged – the directors did not perform their basic duties as a board! Almost all the organizations had board issues. That is not to say there were not smart, dedicated people serving on the boards, but the boards were not functioning as well as required when the crisis started. While it will be hard to have the right board with the scarcity of participants, we must focus on board development. That will put us in competition with each other for the best individuals. While that’s unfortunate, all studies on nonprofit resilience validates that a good board is the most critical element for a nonprofit’s success. Obviously, passion for the mission should be the most important characteristic for whom to recruit – but there are more things to consider. We will expand other signals to watch from the board in points 2-6.
- No director on the board had financial acumen. Almost none of the organizations had someone who truly understood the financials. Almost all the recent crises were financial in nature and happened in organizations without anyone on the board having a financial background. In addition to directors with capacity, every board needs an active finance committee, comprised of those board members with capacity – as well as one or two of their peers, maybe not on the board – to monitor the organization’s finances.
- There were no term limits. Almost all the organizations had directors who served over six years, many more than nine. We worry less about if one, two, or three consecutive three-year terms should be instituted. But we strongly suggest there be terms, along with a limit on how many consecutive terms anyone should fill. Most of the organizations in crisis had directors who served for many (too many) years. Even the most dedicated director, over time, will give less and less oversight. Other things to monitor for the right board also include:
- Maintaining a balance of gender, skills, and people who can see the big picture with those who are good with detail
- Practicing strategic board development, identifying prospects years before they are asked to serve and engaging them as donors and volunteers before asking them to serve.
- Many of the directors were serving on too many boards. This issue is a factor for almost all boards in Alaska. Since we have so few willing prospects to serve on boards in Alaska and we all want the best leaders possible, we ask the people already serving on boards to serve on just one more. Anecdotal evidence tells us that a vast majority of board members are serving on two, three, or four boards. I have personal experience. I currently serve on three national boards. Because I do what I do for a living, I put in the time required for each board. But in honesty, I am struggling to keep up with the demands. And to be fair, they each deserve my best if I agree to serve. Thankfully, I finish my service on one of those this month. However, if that were not the case, I am at that point where I would need to choose one or two that I can manage. If you asked your directors how many boards they serve on, I would bet that at least several would say they also serve on too many. For most mortals, three or four boards are too many.
- The board did not receive ongoing training. Another factor we’ve identified with every organization that has gone into crisis was, as far as we know, none of the boards received training from us, nor anyone else, for many years. We have heard that some directors feel they learned all there was to know. That led us to understand that serving on a board, especially in these times, is not intuitive. People forget the basics. A lot of the nuance of doing the job right is lost over time.
We suggest that every board receive training every two years. None of our partners who engage in ongoing board training have had a crisis – yet. Maybe that’s a coincidence – maybe not.
- Nonprofit executives didn’t engage, inform, and partner with their boards. Many organizations in crisis had executives that controlled information. They limited what should have been data the board reviewed in order to monitor the organization’s mission and operations. In addition, their boards allowed that to happen. There was a lack of transparency – or no partnership. Some of my nonprofit executive colleagues suggest that boards are useless and obsolete. I say to those friends “a utilized board is never useless – it is critical to success.” While the most important job of the board is to identify the right staff leader and the second most important job is managing that relationship, ultimate success requires active monitoring and feedback from the board to that executive. In our sector, shared leadership, between the CEO and the board, is critical.
Too often when a board hires someone with the knowledge to manage the organization’s programs, staff, and finances, it goes to sleep. It stops actively monitoring what is going on. When that happens, it’s not the board’s fault – blame lies with an exec that allows that to happen. Nonprofit executives who do not share power are not competent. New execs should not have as much leeway as experienced execs.
Another word of caution, when an executive has been in a position for more than a decade, many boards begin to trust too much. They stop providing adequate oversight. Either can be a fatal mistake. It is the board’s job to establish policy and direction for the organization. Everything should be done in partnership between the board and the staff leader. That staff leader should be empowered, within the framework of the board’s policies and direction, to determine the right tactics.
Engaging a group of very busy people on the board is the most important job of the executive. Without an engaged board, the legally required oversight cannot happen. Without a board, donors have less assurance that their contributions are used in the way intended. Without a board, the entity is not abiding within the law. It is not the board’s job to micro-manage the day-to-day operation. However that executive should never make a big decision for the organization without the board’s knowledge. The “right people” starts with the right board and continues with the right executive. When power is shared, it creates the appropriate board-staff balance.
- They did not pay payroll taxes!!!! This factor has historically been a clear signal that the end is near. Many of those in crisis were behind in paying these taxes. When cash flow becomes a problem, the absolute worst vendor to not pay is the federal government. As simple as this may sound, failure to keep federal payroll tax current continues to be the number one reason that nonprofits in Alaska get into trouble. The government may not be like a landlord or utility that calls after a couple of missed payments. That is likely why so many nonprofits try to manage limited cash flow by not paying the government. The IRS waits almost a year before making the first inquiry. By then, the damage is done. Many nonprofits never recover. And, if you are on a board and you know that these taxes are not current, you need to be scared. While boards that are doing their best and are informed and engaged and take action have protection in law, failure to pay payroll tax is not something that can be forgiven. Even director’s and officer’s insurance can’t help.
- There was no process to reconcile bank statements. Over half of those in crisis had no formal process to reconcile bank statements. The result – they didn’t know how much money they had. Another very simple remedy for poor financial management is to balance the checkbook. Nonprofits that get into trouble often don’t know what cash they have on hand.
- There was no ongoing review of accounts receivable. Many of those in crisis had their major funding source change the rules with little notice. In that situation, it is hard to accurately predict receivables. Yet, others with a shortage of income could have predicted that outcome with a consistent process to monitor receivables. Since we book receivables as income (accrual accounting), it can be confusing to a board member without financial acumen to understand that what is in the budget as income may just be projected income, not cash. Or that what cash they think they have it really restricted, therefore they may not have as much money as it seems. Nonprofits that practice good financial management openly discuss their receivables and write off income that is delinquent.
- Neither the staff nor the board projected cash flow; there was no strategic budgeting. It’s hard to be strategic when a nonprofit has limited sources of income, especially if a source changes the rules. But all nonprofits should anticipate such disruptions of income and develop scenarios to prepare. Part of that planning would be to build adequate reserves. None of those organizations in crisis engaged in strategic financial planning. Because of the workforce shortage, too many people serve as chief financial officers in large nonprofits, or executive directors in smaller nonprofits, who do not understand how to strategically manage their finances. And, as already stated, often no one on the board has financial acumen. To be more specific, the organization is not capable of being strategic when it puts together and monitors the budget. Every nonprofit that has entered crisis had a failure of its staff and board leadership in financial management.
When we send our consultants to look at the financials of the organizations in crisis, they quickly see what should have been determined by the staff and board months before. Either the organization was spending restricted funds on unrestricted activities – or it was not meeting its income projections but did nothing to reduce costs – or it had a change in funding protocol from one of its primary funders but was unable to make a case of how such decisions would cripple their ability to maintain the current level of service – or it made an informed decision that in order to fulfill its mission it had to spend money, even when they didn’t have a clue of where the money would come from.
I once admitted to a CEO of a large corporation that while Foraker had always come within a percentage or two of its projected revenue and expense, I was just guessing. He assured me that all budgets are guesses, but that a CEO, or CFO, must be good at guessing. Those guesses must be based on the best available data. Such data include the prior years’ history, reconnaissance on funding trends from the primary funders or customers, and then luck. He said that leaders should understand that since they guessed, they should never totally trust their assumptions. They must closely watch the budget from month to month, and as soon as it is clear an assumption was wrong, admit the mistake and make changes immediately. The fatal flaw of the nonprofits that have gone out of business is that the staff or the board held onto hope too long. Unfortunately in most cases that made their situation worse.
In 2008, when the markets crashed, we suggested a practice we learned from one of our Partners, The Nature Conservancy. They developed a budget as usual based on their best current understanding, but then went on to develop two other budgets. Such scenario planning is critical in business planning and in budgeting. They had a “best case” scenario budget in case all potential income was realized, and then did the same for a “worst case” budget. Accompanying those assumptions were the defined expenses that would be cut or increased based on which scenario seemed imminent. We suggest that developing a best and worst-case budget is prudent during crisis, and it’s prudent when times are good.
We recommend that every nonprofit plan ahead for potential income shortfalls. Decide now what expenses will be cut. Of course that is something most of us would rather not do, but such an exercise can help clarify the best steps when confronted with that situation. Don’t wait until the crisis.
The board CEO relationship is based on trust – it is a partnership. Surprises are never good in partnerships. Competent financials management requires individuals to be strategic, not reactive. That is not to say that there will not be some times when a loss of revenue or an unexpected expense won’t trip us up. But if that kind of surprise becomes routine, there is a problem.
Those organizations in crisis shared a couple of other factors. Some reported growing too fast, and while related to #10 or to not having a strategic financial plan, it seems relevant enough to mention. A couple of others got into trouble because they built a facility that they could not sustain. By the way, no organization that participated in the Foraker Pre-Development Program had that issue.
As these crises continue and we learn more, we will continue to share. Even nonprofits with the right board and staff, strategic partnerships, and the best possible sustainable funding mix could expect challenges over the next years. If you begin to feel complacent, take notice. Our job as nonprofit leaders is to adapt to whatever the environment throws at us. Our missions depend on our ability to do the basics right, keep an eye on what’s coming, be willing to make hard decisions quickly, identify mistakes, fix them, then move on and adapt.
Many have reached out. That’s a good first step.