Why capital markets are tough for scrappy non-profits

Colleagues meet in a room overlooking the city

America is applauded around the world for the strength of our nonprofit sector, and in particular for our vibrant community organizations – from churches and boys’ clubs to arts centers and social welfare organizations. And Americans are the world’s most generous benefactors of such organizations.

It turns out, however, that capital markets do not work all that well for up-and-coming social welfare groups. But with some timely financing reforms, the sector could be an even more potent solution to many social problems facing the country.

Innovative for-profit startups have a well-developed financing path to foster creation and expansion. It is still relatively easy for new ideas to take shape in garages and basements, with little cost and regulation. If they survive this initial stage and remain promising, they have access to broad forms of capital to help them grow during the second, expansion phase. Capital is likely to be available from family investors and venture capital firms, or from new sources, like Kickstarter. If they reach the final stage of becoming established and widely known, they can expect sales and institutional funders like banks and stock sales to sustain their expansion.

Social welfare entrepreneurs, by contrast, face a lot more uncertainty and challenges than the basement commercial startup. Regulation is one issue. Very small organizations that help former inmates reenter society or address the complex health needs of low-income children may be able to fly under the regulatory radar. But once they are large enough to get noticed, licensing requirements and other forms of red tape often push up costs and limit their flexibility and creativity.

If the organization survives that early stage and begins to grow, typically it has to attract venture capital or ongoing operational funds from one of two sources – grant-making private foundations or government programs. Only after growing sufficiently during this second stage is it likely to reach the scale and public profile needed to reach the third stage, where it can generate sustained funding from campaigns that can attract large numbers of contributors.

That second, growth stage is an especially risky one for nonprofit social welfare organizations. True, foundations can be a large and important source of funds. But increasingly, foundations demand clearer evidence that organizations are producing measurable results before they will support them for a sustained period. Seeking good value for money is an understandable impulse. But it can also have a downside. Conditioning support during this stage on rigorous evaluation means fledgling ventures need to collect extensive and specialized data, and may be required to demonstrate effectiveness over a lengthy period. Unfortunately, that type of data is often expensive and time-consuming to collect, and may be quite different from the operational data an organization needs to run and fine-tune its daily activities. That can put the organization at financial risk. A major evaluation can also freeze innovation by forcing the organization to stick with one approach to solving a social problem throughout a drawn-out evaluation period, rather than continuously refining its strategy or trying out modified approaches. As Ricardo Hausman, an international development expert at Harvard puts it, requiring too intensive evaluation too early is “equivalent to putting auditors in charge of the R&D department.”

Financial support from government programs, meanwhile, is typically very siloed. So a small social service organization doing a great job by tackling multiple dimensions of a community problem may have to apply for grants from several programs, each with its own reporting and evaluation requirements and restrictions on how its money can be spent.

So how can we make the capital market and other forms of financing for creative social welfare nonprofits more like capital for innovative business startups?

One step would be to reduce red tape during the garage/basement phase so that ventures can get off the ground more easily, with fewer restrictions on who they hire and what they do. The Center for Neighborhood Enterprise is an organization representing low-income neighborhood groups that has been campaigning for reduced licensing requirements, in order to permit unorthodox approaches to social problems to be tried out, such as using former inmates to help reduce youth violence.

To help organizations through the second, expansion phase, foundations and government could help by providing more funds for building a strong data collection and processing infrastructure. These funders could also be more patient before demanding rigorous evaluation studies.

Federal, state and local governments could also make it easier for fledgling social nonprofits to handle the paperwork involved in receiving support from several programs by adopting some form of Maryland’s Local Management Boards (LMBs). These county-level bodies can be public or nonprofit institutions and act as financial intermediaries. The LMBs blend together money from multiple public and even private programs and handle some or all of the reporting and evaluation requirements for the money they pass through to community-based grantees, reducing organizations’ bookkeeping burdens and increasing their flexibility.

It is also important to foster new forms of capital for more sophisticated organizations breaking new ground – where government is reluctant to take a financial risk. Social Impact Bonds (SIBs) are a promising example. With SIBs and other forms of “pay for success” financing, state or local governments tap private investors to cover the upfront costs of a new approach to such problems as homelessness and recidivism. If rigorous evaluation shows success, government repays investors and provides a return on the investment. If it is not, investors shoulder the loss. So pay for success provides a profit incentive for private investors to seek out and support creative social initiatives. Congress is now consideringlegislation that would share in a local government’s cost of paying SIB investors. That could expand the volume of SIB investments.

We can be justly proud of America’s nonprofit sector, and especially community-based organizations. But to help them to succeed in tackling social problems, we need more effective capital markets to encourage start-ups and foster their growth and innovation.