Beware of Throwing Good Money After Bad

…financial due diligence can reduce risks of philanthropic giving

by David Roth and Ardie Geldman

Dollars are dear

The ongoing economic crisis has made philanthropic dollars more precious. Demand for nonprofit programs and services and for the financial resources to carry them out far outstrips supply. Further, no one knows when the crisis will end. Nonprofits that manage to stay afloat this year on a shoestring budget may face even greater difficulties in 2010 and beyond. Simply put, there is less money available to warrant the same level of risk-taking and continuing to “do business as usual.”

Throwing money away

One of the greatest risks is donating money to an organization that is likely to fail in the near future. When this occurs, we can point to three losses: first, the organization that doesn’t truly benefit from the funds, second, the organization that misses obtaining those funds, and third, the donor who becomes disenchanted and rueful after having been burned.

Case studies

In our work, we have come across organizations that were at high risk of going out of business. Consider the following cases:

  • Organization ABC has a cumulative deficit equal to 50% of its annual budget. The bulk of the deficit was incurred several years ago, but it continues to grow annually as its expenses exceed its actual income. The deficit takes the form of a bank loan that is renewed annually, and on which ABC pays an interest rate of 10%. The organization often struggles to repay its loans, and is occasionally unable to make payroll or pay its suppliers. Donations are considered fungible and are first used to cover bank interest and pay off debts, as the organization is always lagging behind by incurring expenses it cannot afford. ABC does not have any fixed or long-term assets, and if it were to shut down today, it would find itself unable to pay off its creditors.
  • Organization XYZ used to consider itself lucky. Early on, its founder secured funding from four venture philanthropist “angels” who together contributed 95% of its income. With funding supposedly guaranteed, XYZ did not bother to develop an active board of lay leaders, carry out public relations, or embark on fundraising activities to cultivate a broader base of committed donors. The current economic crisis forced two of the benefactors to reduce their funding by 50%, while the Madoff scandal completely wiped out a third funder. The fourth donor’s financial situation has also been affected, and since he cannot pick up the slack he decides to cut his losses and terminate his funding.
  • Organization JKL is a small and relatively new nonprofit. Like many Israeli start-ups, the founder began to develop and run her program without knowing when and how she would succeed in raising funds. She began by using her own money, enlisting volunteers and other forms of in-kind support. With “facts on the ground,” she was able to approach several potential donors, but ended up receiving less money than she has envisioned. Struggling to survive even before the economic crisis, JKL’s financial situation grew more precarious over the past year. The sum she needs is not high – about $25,000, but this is the barebones minimum, and she won’t be able to make it if she only raises $15,000. JKL doesn’t know what its chances are of raising this sum.

The risks

The cases above pinpoint several key risk factors that indicate financial instability and could inadvertently cause your donation to be offered in vain.

  1. Deficit (organization ABC) – an organization whose liabilities exceed its assets has a deficit, which makes it very difficult to run an organization. The organization could secure bank loans to enable it to continue spending money, but as a debt, the organization ultimately owes this money to its creditors. A relatively small and infrequent operating deficit is not the end of the world, if the organization makes sure to include it in its budget for the coming year. Chronic and/or large deficits are red flags that signal that the organization is in danger.
  2. All eggs in one basket (organization XYZ) – an organization that fails to diversify its income sources is at high risk of losing everything if those limited sources dry up. Nonprofit income is generally derived from three broad areas: philanthropy, government, and earned income. Philanthropic income can be further diversified by source (foundation, corporation, private donor), size of the gift (large, medium, small), geography (USA, Israel), and method (direct mail, online, face to face solicitation, events, etc.). An organization that relies upon a few sources of income is putting its existence at great risk.
  3. Lack of guaranteed income (organization JKL) – an organization that lacks a stable cash flow and regular sources of income is at risk because it does not know whether donors who gave in the past will continue to give. Beyond wishful thinking, there are no efforts to raise multi-year gifts, engage in ongoing donor cultivation and retention efforts, or know whether gifts will arrive in advance. To exacerbate matters, many donors delay their giving until the end of the fiscal year. This lack of information makes it nearly impossible to know whether it can afford to carry out its programs, hire staff, etc. or not. This uncertainty factor forces the organization to live hand to mouth.

Minimizing the risks

In the stock market, investors buy and sell shares based on a company’s financial position and a professional analyst’s reports. It is unlikely that any investor would buy shares in a company if it appeared that the company was about to go bankrupt.

Why should philanthropic giving be any different? Before deciding whether to contribute, a donor should request more detailed information about the potential beneficiary organization’s financial situation. Financial documents – including operating budgets, lists of income sources, balance sheets, cash flow, and other records – need to be carefully reviewed and scrutinized to determine financial stability; diversification of income sources; probability of income being received; and whether there is a cumulative deficit.

A further step, especially called for during these difficult times, is for the donor to directly communicate with the potential beneficiary organization’s other main funders. Assuming a small number of donors contribute most of the philanthropic funds, this is not implausible. Such contact will shed light on whether other funders are planning to reduce or even end their funding to the organization while providing an opportunity to gain additional insights into the organization’s financial situation.

A donor’s options

If an organization’s other main funders are planning on reducing or ending their funding, the donor has several options:

  1. Follow – the donor follows suit and also reduces or ends his funding to the organization
  2. Lead – the donor lobbies the other funders to continue their support.
  3. Go solo – the donor decides to continue funding even without the others. This would be most appropriate in a case where the donor has sufficient funds to make up the shortfall, or when the donor’s funds can be used to build the organization’s capacity to adapt to the changing environment. This might include exploring possibilities to consolidate and/or collaborate with other organizations.

Minimize the risks and save money

The present economic crisis has produced additional risks to donating money. Donors that make a major gift without performing financial due diligence might inadvertently throw good money after bad. Investing in initial research for a relatively small sum can save the donor tens of thousands of dollars or more that can be applied to the most worthy causes.

logoDavid Roth and Ardie Geldman are philanthropic consultants with Donor Associates in Israel, Ltd. and regular contributors to eJewish Philanthropy. Donor Associates in Israel, Ltd. (DAI) exists to guide donors in making wise philanthropic decisions. We invite you to touch base with us for an initial consultation prior to making your next major gift to Israel.