When Should a Nonprofit Go Out of Business?
According to the Small Business Administration, one-third of small businesses cease operating within two years of their incorporation and only 44% survive through four. A new employer only has a 50-50 chance of survival.
It’s hard to find comparable statistics for the nonprofit sector, but in our experience, it’s harder to get a nonprofit to go out of business than to get a man on Mars. I believe we will walk on Mars but have less faith that nonprofit organizations (that are no longer viable) will go out of business like their for-profit counterparts.
Having reviewed research on nonprofit dissolutionment, the only credible source found was Guidestar, which estimated that as many as 40,000-60,000 charitable nonprofits went out of business during the past year. If that is true, less than 4% of charitable nonprofits went out of business. Even if we were to double that estimate, it’s apparent that far fewer nonprofits fail in the first two years when compared to small businesses. IRS data reports that 45,000-65,000 nonprofits are formed every year. Therefore, we can assume that the sector continues to create as many or more new organizations as it loses each year.
Do so few nonprofits fail because they are so much better managed than for-profit small businesses?
Nonprofits have advantages over for-profit businesses such as their tax status and compelling missions that inspire those involved to extraordinary effort. But any asset can also be a liability. The tendency toward extreme commitment often keeps well-meaning people overly invested in a vision that may no longer be viable. One reason why nonprofits do not fail is that the people that founded them, or that have invested decades into their mission, will not let them fail. And as long as people are willing to work for nothing, a nonprofit can survive for a long time. Most small businesses cannot find people to work for nothing.
Is it bad that dedicated people exhibit such tenacity?
A tenant of the nonprofit sector is to support the “common good.” The nonprofit tax status requires a charitable purpose. Our sector is composed of selfless people who are willing to engage in heroic efforts. In our book Focus on Sustainability: A Nonprofit’s Journey, we confirm that sustainability is based on more than just money. The passion and zeal exhibited by nonprofit leaders for their mission is truly inspirational, but also gets in the way of rational decisions. It is the board’s job to make decisions that are in the best interest of the corporation. Prudent decisions are required. Balancing risk with opportunity is at the nexus of prudence. It seems that the tenacity of those involved can get in the way of making prudent decisions.
How can you tell when a nonprofit is not sustainable?
The behaviors to monitor are also addressed by the Foraker Nonprofit Sustainability Model.
The first behavior is when an organization takes on programs not related to its founding purpose. The main cause of this phenomenon is putting funding ahead of mission — or “mission drift.” A nonprofit must stay true to its founder’s vision in order to be sustainable. Programs and services can change over time as long as the original intent (purpose) is at the center of that decision. Whenever a nonprofit seeks grants as its economic engine, it will eventually lose focus because few grants are renewable and others demand continued changes in direction. Money drives the mission rather than the mission driving income. When a nonprofit loses focus, it is no longer viable.
The next behavior is the easiest to observe. Does the organization have adequate human resources – the “right people?” If one witnesses a nonprofit with a revolving door of staff leadership, it can be surmised that within that organization there are additional staffing and governance issues that may not be as easy to see – this can result in the lack of enough right people who are committed to the ongoing success of that institution. In the January 2011 newsletter, we published the trends Alaskan nonprofits could expect over the coming years. One of those trends was called “the crash of the herd” and referred to the over-abundance of nonprofits in Alaska – possibly too many to sustain. We suggested that so many nonprofits with our limited population could eventually lead to a shortage of the right people. The scarcity of the right people is a two-fold conundrum – nonprofits must have enough of the right people to serve on their boards and they must be able to attract and retain the right staff leaders. We predicted that both pools were already in short supply and the problem will get worse. Today we are witnessing what was predicted. At The Foraker Group we are receiving a steady stream of calls from nonprofits that have had a failure of staff leadership – people probably not qualified for the positions they hold. We also hear from nonprofit boards that cannot find, nor retain committed board leadership. Our projection was that human scarcity would be an issue for at least a decade. Recent experience lets us know that we are only into the first year of this scarcity. If a nonprofit cannot keep the right people involved, it is no longer viable.
The third sustainability factor, partnerships, could be less clear. However, an informed observer can witness an organization entering into what could be described as an entrenchment mode. We have observed that many organizations in the first stage of their demise begin to isolate themselves. Without early intervention this isolation exacerbates the problem, increasing the likelihood of their eventual failure. Unchecked, failing nonprofits will stay entrenched until it’s too late. When leaders fully understand the situation, they will begin an urgent search for solutions. That solution often entails looking for a partner to merge with. In our sustainability model, we observe that viable nonprofits engage in ongoing strategic alliances – they don’t wait for a crisis. Everybody on the staff and board can identify their most important partners. It is hard to ask for help, but when a nonprofit is in a hunker-down (isolation) mode, on the verge of failure, it must look around and find assistance. Reaching out at the last minute indicates that the nonprofit is no longer viable.
The lack of funding is usually the very last factor to influence a board and staff about whether their nonprofit is viable or not. That may seem strange since most people associate funding as the only important factor for sustainability. In our experience, we observe many, many organizations survive for decades with very limited funding. As long as the organization maintains focus and keeps the right people and partnerships, it can be sustained for a long time with almost no money. That is why we think that the lack of money is actually the least important factor influencing the nonprofit’s decision to go out of business, or not. Some organizations in a funding crisis use a lack of money to raise money. Certain donors wait for an urgent call from a nonprofit that lost funding to “save the day.” (We find it strange that many donors reward poor business practice with generosity.) Most sophisticated donors refuse to fund an organization that is holding a “fire sale.” The problem with bailing out an organization in financial crisis is that unless the people involved in managing and governing the organization change the behavior that led to the crisis, emergency fundraising is futile. The organization may live for a week, a month, or a year – but it will usually not survive.
What can you do if you are involved in an organization that has lost momentum – that seems to be on the verge of closing its doors?
Ten years ago there were only a few nonprofits that reported that they were in so much turmoil they considered going out of business. Today is a different story. We have more nonprofit leaders that see that their organization is in trouble. We hope that trend of honest reflection continues because once the internal leadership admits that their nonpoint is no longer viable, our work is easy. However even with this growing number of enlightened leaders, we continue to see too many nonprofits in crisis, where the leadership is still reluctant to let go.
When an organization’s leaders admit that the end is near, the approach is straightforward.
- The organization completes a financial assessment to determine its assets and liabilities.
- If the organization has more assets than liabilities, its goes to the next step.
- When the organization has more liabilities than assets, the board may seek legal/financial counsel to determine personal liability of its directors (the board). In most cases, directors and officers insurance policies will help to cover liabilities, but if the liabilities are excessive or not covered by D&O Insurance, the board may have hard conversations about how to minimize personal liability. (If you are in such a situation, please contact Foraker. We have the expertise to help most boards through that discussion.)
- The organization looks to identify an organization that has a similar mission to ensure that its most needed services are maintained. If the organization that is going out of business can find such a host, it can make the transition much less painful.
- If there is a match, the organizations involved work though a formal understanding of how the transfer of mission, and possibly assets, will proceed.
- It is prudent for both boards to engage in a meaningful due diligence process to limit surprises.
- A formal document should be developed where both parties attest to the arrangement.
- The organization that is going out of business begins a formal dissolutionment process where it notifies the state and IRS of the situation, holds a small trust for unexpected liabilities for a period of time, and ceases to exist. (These steps are overly simplified. If your organization faces dissolutionment, we suggest you call our office, or seek financial and/or legal counsel.)
Unfortunately, many nonprofit leaders are still reluctant to admit that their organization, the one they have nurtured for years, is no longer a going concern. We have seen many of those leaders go into denial, much like a family member when a loved one receives a terminal diagnosis. The institution is like family – and letting go is not easy.
In our last economic study we reported there were 7,000 nonprofits in Alaska. However, we found that there were actually over 8,000 incorporated not-for-profit corporations registered with the state. That means that many nonprofits never revoked their incorporation. One of Alaska’s oldest nonprofits has not engaged in its stated purpose for many years, but its board refuses to go through dissolutionment. This reminds me of putting a loved one on life support with little, if any, hope for survival.
It is the will of the board that either founds or dissolves a corporation. It seems that in the business world, when one fails, the owner (board) does what is necessary to cease business and go to the next venture. In the nonprofit world, we are less able to take that step. There are exceptions. In the past weeks, at least three boards began the process of dissolutionment.
In our opinion, when a nonprofit’s mission does not inspire the engagement of the right people or partners, it starts a downward cycle that will eventually lead to not generating enough revenue. When income goes down, the nonprofit must either live off the generosity of volunteers who will work for nothing, or dip into reserves, or dissolve. Neither voluntary effort nor living off reserves is a long-term strategy. Volunteers will eventually burn out. The problem with living off reserves is that at some point a donor’s intent is no longer being honored. This happens because the donor gave hard-earned money for a particular mission and the mission is no longer being addressed. Through dissolutionment, the nonprofit’s assets must be transferred to another charitable organization with a similar purpose – at least with that action the donor’s intent can be maintained.
In the January 2011 newsletter article I mentioned earlier, in addition to the “crash of the herd,” we predicted that there would be an increasing need to rethink structures in all institutions. Part of that trend demands an acceptance that nothing, including a great institution we founded or nurtured, is going to be around forever. As death is part of life – dissolutionment is part of founding. If our favorite organization only succeeds for a couple of years or it has momentum to sustain services for a century or more, when those involved did their best for the greater good throughout its existence, they were a part of a successful nonprofit. In other words, going out of business is not a failure if the mission was accomplished. However, keeping an organization in business that is no longer viable is a failure.
In the post-script of Focus on Sustainability we say, “We have concluded that it’s not your organization that must survive – it’s your mission. Those involved with the nonprofit sector should make sure that critical missions endure, and that meeting them is everyone’s first priority.”