The following is the third chapter in my new book "Scaling Social Entrepreneurship: Lessons learned from One Laptop per Child". The book is available in paperback and e-book versions on Amazon.
Chapter III- Non-profit Foundations and Their Influence on Social Entrepreneurship
While government’s ability to serve the public good and provide social services should probably always have been in question, one response to the underserved needs of society was met in part through non-profit foundations. Non-profit organizations for social purposes date back several centuries. One of the first efforts to legally codify such matters was in England in 1602[i]. An historian might cite earlier efforts to formalize non-profit activities, perhaps looking at collectives, guilds or buying groups. The long history of foundations and the provision of social services also had a profound effect on how people think about social entrepreneurship and many SEVs elect non-profit status as their legal form of organization. Whether or not that is the best choice will be discussed in this and later chapters.
We return to Hansmann (1980) for a comprehensive definition of the non-profit foundation. To summarize Hansmann, non-profits typically have four characteristics:
- They do not distribute excess cash flow to stakeholders
- They serve the “public good”
- They subsidize the consumption of others
- They maintain a “trust” in the non-distribution constraint
Hansmann’s first characteristic of a non-profit is that by their selection of a particular form of organization under the tax code (in the U.S.), they are barred from returning any excess cash flow to individuals who exercise control such as officers, directors or trustees. Any excess cash flow must be re-invested in assets to provide the services of the non-profit or in the operating activities of the organization.
Hansmann's second characteristic, the definition of the public good, was explained in the last chapter.
Non-profits are traditionally subsidy providers, lowering the cost of a product or service or offering them for free to those who cannot pay market prices. By not having the motivation and contractual obligation to provide a return to shareholders, non-profits are free to lower margins or provide the goods and services at below cost (including for free), thereby using their funding to provide the subsidy to the presumed less fortunate. Non-profits as subsidy providers also explain funding for certain performing arts, where the demand for performances is too small to justify a for-profit company providing the service. Another example may be donations to educational institutions where the donations subsidize scholarships that cannot be made from the educational institution’s cash flow or from government support.
Hansmann’s last characteristic of a non-profit is perhaps the most insightful and provides an understanding of a real service provided by non-profits. Non-profits serve as “trustees” for their donors. Much of serving the public good is difficult to monitor, particularly when the activities are across the world in Asia or Africa. Non-profits have no incentive not to provide their service and no incentive except to provide their product or service at the lowest cost possible. A for profit company seeking return for shareholders might not send all the food to the needy children in Africa or might overstate the cost of the food to enrich shareholders, but Hansmann believes that non-profits have no such self-interest.
While many would laud non-profits for their lack of self-interest, I think the professed absence of self-interest is the shortcoming in non-profits and perhaps one of the reasons that the social entrepreneurship venture has emerged as a viable alternative to execute social projects.
The absence of self-interest in non-profits causes two problems for non-profits:
- There is no incentive for non-profits to be efficient. It is widely recognized in economic theory that every exchange of a product or service is based on each party believing that the exchange serves their self-interest. The provider of the product or service achieves this end by operating as efficiently as possible and by charging as much as the purchaser will bear. However, the non-profit is subsidizing the purchaser price and thereby distorting the market determination of price. With the market price distorted the incentive to be an efficient producer becomes distorted as well and may lead to less attention to operating efficiency. Hansmann makes the same point differently: “It is almost certainly true that nonprofit firms are productively inefficient in the sense that…they will generally produce any good or service at a higher cost than would a for-profit firm. If it were otherwise, we would expect to find non-profits operating in a much broader range of industries than is actually the case.” Complaints over the last several years about the high percentage of administrative costs in non-profit foundations might support this conclusion.
- There is no incentive for non-profits to scale their operations. There are approximately 1.5 million non-profit organizations in the U.S., roughly one for every four tax paying corporations. The average non-profit had annual revenues in 2011 of $1.1 million and two percent have revenues over $10 million[iii]. Why are the non-profits so small in terms of scale? Non-profits do not have the incentive of self-interest from the derived economic benefits of scaling. In fact, I believe self-interest leads to the proliferation of small non-profits. Many people do not want to “anonymously” contribute to a large foundation like the Gates Foundation that is tackling the large problems on a worldwide scale. People apparently prefer to get the personal recognition of establishing their own small non-profit foundation. In certain communities it has become a status symbol to say you have a foundation. While personally satisfying, small foundations typically provide only incremental solutions and rarely address the big social problems that require scale of operations. Some would argue that there is a place for small foundations and that in some communities they aggregate resources in order to achieve economies of scale, etc. However, foundations aggregating resources are rare. Many small, stand alone foundations effectively duplicate overhead where such financial resources could be more efficiently deployed to address the actual social problems. When we examine the industries in which non-profits operate we recognize that they are generally similar to small business industries, industries that can achieve positive cash flow without any significant scaling. Otherwise, non-profits might be operating steel mills and building automobiles or conducting mining operations in Chile. The industries of small business and non-profits are typically also less capital intensive and therefore do not need access to capital markets to fund investment in new facilities or significant working capital requirements. A recent trend is for non-profit hospitals to convert to for-profit tax status or be acquired by for-profit hospital chains. Such moves are prompted by the need to expand their facilities or locations and achieve better economies of scale. These moves also give the organizations better access to expansion capital, which demonstrates a shortcoming in non-profit status.
Foundations require capital or expansion capital when they address large-scale worldwide problems. While historically foundations have operated with the characteristics of small businesses, as described earlier, tackling worldwide problems requires large amounts of capital to build international partnerships and distribution, to fund working capital and to fund continued innovation in product or service. In my experience commercial banks and investment banks will not finance a non-profit regardless of the scale of its revenues and cash flow. For example, almost every leading bank in the world I approached to commercially finance OLPC, despite annual revenues approaching $100 million and positive cash flow, turned me down. If the objective is to address large, worldwide social problems, access to commercial capital markets is required and the organization should elect to be a for-profit corporation rather than a non-profit foundation.
It may be noted at this point that there has been no mention of the word “donations”. It should also be pointed out that Hansmann made no use of donations in his definition at the beginning of this discussion of non-profit foundations. Foundations that rely principally on donations are called “donative foundations”. Foundations that rely on sales of product for cash flow may in certain cases be described as SEVs, as later explained in the discussion of the three forms of social entrepreneurship. Interestingly, at a recent speech to over 100 executives from non-profit organizations, when I asked them why they were non-profits they all answered, “to receive tax deductible donations”. This is what I call the “default” answer for a social organization. If you do not think about it, your social venture defaults to being a non-profit and accepts donations.
There are four possible reasons to actively select non-profit status:
- Access to capital not available in commercial markets Certain projects cannot easily be financed in the commercial financial markets. Museums and performing art centers would be the two most common examples. These types of projects cannot create sufficient cash flow to attract loans and equity investors. Therefore, they can only be created and funded through donations to non-profit foundations.
- Lower costs through volunteer communities Certain projects need to use the free labor of volunteers in order to be self-sustaining on a cash flow basis. For example, OLPC probably would have needed $20-30 million in additional donations to develop Sugar, the educational software on the OLPC laptop. A worldwide community of volunteers has created over 300 educational Sugar apps.
- Partnering with NGOs, governments, multi-laterals and universities Certain social projects believe that they need to partner with NGOs (non-governmental organizations), governments, multi-laterals and universities in order to achieve their social objectives. The large NGOs and multi-lateral organizations have a wealth of experience in social issues, staff across the globe with local knowledge and resources that can be leveraged to achieve more effective operations. These types of organizations are all non-profit friendly and share concerns to differing degrees about the “self-interest” of the private sector. Therefore, it may be easier to partner with multi-laterals and NGOs if the organization is a non-profit foundation.
- Branding Branding, defined as, “product positioning and messaging in order to achieve emotional engagement with the user for eventual economic benefit to the seller”, can be enhanced by non-profit status. For example, if the social venture is communicating a “low cost” solution, non-profit status implicitly communicates lower margins and prices.
While these four benefits to non-profit status may be attractive, a for-profit company can also achieve all of these benefits. A deliberate review of a new organization’s social mission and strategy should include a methodical analysis of whether the organization’s objectives are better served by non-profit or for-profit status. Unless the social project cannot generate sufficient cash flow to access capital markets, such as museums and performing arts centers, I recommend for-profit social entrepreneurship rather than a non-profit foundation.