Impact Investing: Implications for Nonprofit Funding
by Paul Hanvongse, Ph.D.
We might look back at the period between 2000 – 2014 as the crucial intersection of three narratives coming together to tip the social sector in a new and exciting direction. In this article, I tie together three different developments to demonstrate how the nonprofit sector is on the verge of massive change. First, I discuss the debate surrounding restricted funding. Next, I discuss the rise of impact investing, particularly as a way to lower reliance on restricted donations by diversifying funding sources. Finally, I discuss how nonprofit organizations can position themselves to take advantage of what impact investing has to offer when they make a distinction between revenue and investment (Overholser, 2006).
The Limitations of Restricted Funding
The merits of restricted funding and their supposed benefits have been highly contested among nonprofit practitioners. The case against restricted funding was most effectively illustrated in the now classic ‘Nonprofit Starvation Cycle’ (Gregory & Howard, 2009). Practitioners argue that funders often have unrealistic expectations about what it takes to run and grow an organization, underestimating how much overhead and administrative costs are necessary. Funders, using reliance on donations as leverage, compel nonprofit managers to underreport overhead and operational costs to maintain their eligibility for grants. As organizations routinely underreport fundraising costs, management, and operational expenses, they back themselves into a position to make do with their limited funds, continuing to neglect investment in infrastructure and capacity building that will allow them to sustainably make mission impact and/or scale up as needed. Dan Pallotta has made a similar argument that nonprofits need to change their view of overhead and encourage greater risk taking, infrastructure investment and overall rethinking of the nonprofit business model (see Pallotta, 2008).
Restricted donations are given in the name of accountability and control. They provide donors with quick, clear-cut results and a false sense that their funds are being used effectively. Donors assume to know more about a given problem than people working on the ground (Cameron, 2010). While restricted funding is given with the intention of having more substantive impact (Starr, 2011), it has been argued that funders erroneously focus on organizational overhead and operational costs, rather than focusing on the actual social outcomes. Donors often do not understand that indirect expenses are just as mission-critical.
Despite the negatives associated with restricted funding, these practices persist and appear to be on the uptrend, particularly among the affluent (Forbes Insights, 2012; Mento, 2012). Unfortunately, practitioners argue, restricted funds place nonprofit organizations in a position of having to make trade-offs between enterprise growth versus social mission impact. Paradoxically, donors may end up compromising the mission they are trying to support, in the long-term, for the security of short-term, clear-cut financial ratios.
Yet, the narrative against restricted funding shields a deeper underlying problem. There is unmet demand in the nonprofit sector for philanthropic equity capital (Miller, 2008). Nonprofit organizations get themselves into trouble when they use restricted funding for enterprise building, outside of the program expenses they were meant to support. Organizations contribute to this problem when they fail to diversify their funding base, inadvertently using restricted funding (revenue) for enterprise growth that requires investment. In the process, they appeal to donors to change their attitudes towards the organizations they are funding. Donors are increasingly being asked to behave like investors, when that may not be desirable for all donors. Fortunately, the rise of impact investing provides an opportunity for diversified funding and, where desirable, for donors to behave like investors.
Introduction to Impact Investing
Impact investing is widely defined as the use of profit-seeking investment to generate social and environmental outcomes (Freireich & Fulton, 2009). As the lines between business and social sectors continue to blur, impact investing has emerged as one of the latest innovations to address social/environmental issues beyond the scope of purely philanthropic and developmental assistance. Proponents of impact investing argue that private capital is needed to tackle these problems in a sustainable and scalable manner. A recent Global Social Finance report by J.P. Morgan and the Global Impact Investment Network (GIIN) reported $10.6 billion USD committed in 2013 and projected to reach $500 billion in investments by 2020, exceeding total philanthropic giving (IRIS Data Report, 2011).
In 2011, GIIN released a performance report sampling 463 organizations, including nonprofits that had sought investment capital through intermediaries. Intermediaries connect investors (i.e., high net-worth individuals, family firms, foundations) and investees (i.e., mission-driven businesses, cooperatives and nonprofit organizations) by providing both financial and platform innovation to bring together a range of investors with different impact- and financial- return expectations and risk tolerance. In addition to fund managers, the impact investing ecosystem includes: incubators/accelerators, networking groups, intermediaries, asset owners, service providers, conference organizers, business plan competitions, crowd-funding, deal flow networks and more. In short, impact investing is not only a vibrant and growing industry; it is an ecosystem consisting of multiple players.
Impact investing evolved out of a broader trend in social responsibility investing where companies that perform poorly on a set of social and environmental screens are excluded from investment. What makes impact investing unique is psychological. Institutions that engage in impact investing intend for both social and financial returns. Impact investing is a much more direct approach, seeking to actively deploy capital towards enterprises that have an explicit social mission. What’s exciting about impact investing is it’s potential to address the shortage of nonprofit growth capital needed for enterprise capacity building and scaling (Miller, 2008).
Impact Investing: An Additional Source of Nonprofit Funding
Impact Investing is positioned to meet the demand among growing nonprofit organizations for equity capital. What makes impact investing exciting is the diversity of investment vehicles available, including: grants, philanthropic equity, quasi-equity, loan guarantee and debt (see diagram below).
Grants are best as ‘upfront’ investments in the R&D and ‘startup’ stages of organizational growth. Grants clearly fall on the impact-first end of the continuum, but are technically not considered investments. As shown in the diagram, grants are a crucial source of growth capital. Next, philanthropic equity can be used to support proof of concept, growth and scale. Philanthropic equity may be most appropriate where cash flow is uncertain, yet there is growth potential. Alternatives to equity include loan guarantee and quasi-equity (see diagram and table). On the other hand, debt can be useful provided the organization can generate sufficient revenue (i.e., cash flow) to make payment as well as continue to invest in its own growth. This may be appropriate for organizations that have passed break-even point where revenue exceeds expenses. However, debt is of limited usefulness for ‘scaling a business’ where profitability is marginal or missing. Therefore, debt is most appropriate for organizations that have already achieved sustainability (see ‘break-even’ in diagram) and are looking to expand operations.
Different investment instruments can be mapped along a continuum from impact-first to finance-first, which is associated with a level of risk tolerance. Presumably, impact-first investors are willing to bear the risk of not generating financial returns. They would invest earlier in the life of an organization that needed grants and equity to scale and sustain operations. Of course, the organization would monitor burn-rate until break-even when revenue exceeds costs with surplus. On the other end of the continuum, finance-first investors are more risk-averse and would prioritize generating a financial return along with social returns.
With impact investing, nonprofit organizations have an opportunity to attract different types of investors and instruments at different stages of the enterprise growth (see diagram). The heart of impact investing is segmenting between different investors with different risk tolerance and return expectations. Funds may bring together more risk-bearing investors to front early-stage costs, paving the way for later-stage investors who are more risk-averse.
While coordinating between these different investors is anything but simple, it fortuitously positions the nonprofit investee for diversified funding sources and, in some cases, may even reduce the reliance on restricted donations. Diversified funding ensures that nonprofit organizations are not too reliant on any one source, tempering any potential power differential between a granter and the organization (Starr, 2011). Furthermore, it also allows for the nonprofit to invest in organizational capacity building (as well as the crucial administrative and operational costs) without using restricted donations.
Finally, the rise of impact investing directly impacts funder attitudes. Practitioners have called on funders to eschew restricted funds and offer more philanthropic equity.
While attitudes have been slow to change, the rise of impact investing may serve as the catalyst to illustrate how more investors, in addition to donors, are needed to bringing about social change. Nevertheless, only nonprofit organizations that make a distinction between revenue and investment are in a position to take advantage of impact investing. The next section examines this issue further.
Revenue versus Investment
Nonprofit accounting standards do not distinguish between revenue and investment (Overholser, 2006). George Overholser examined the propensity of nonprofits to confuse revenue and investment funds in their accounting. In the now classic ‘Buyers are not Builders’ article, he described how nonprofit organizations need investment capital to offset the costs of building up the enterprise. During this crucial phase, the nonprofit organization will consume capital at a faster rate than it can generate revenue (see ‘burn rate’ in diagram). Investment capital is needed to keep the enterprise afloat until it begins generating enough surplus revenue to begin ‘building’ the enterprise (i.e., after breakeven).
Confusing investment with revenue leads managers into a false sense of security, thinking they can relax until the next round of investment capital comes in, when in fact, they should be concerned with their inability to be independently sustainable. Managers may unknowingly use investment funds to cover day-to-day program costs rather than enterprise capacity building (i.e., infrastructure, IT systems, equipment). This masks organizational inefficiency, further leading investors to continually fund chronically underperforming nonprofit organizations that may not ever generate enough revenue to be truly sustainable.
If nonprofit organizations made the crucial distinction between revenue and investment, restricted funding could be accepted for what it is: one among many sources of revenue. This distinction dissolves the dilemma where ‘enterprise growth’ is pitted against ‘social mission.’ This framework creates space for both revenue that is used to run programs and investments that are used to build the enterprise capacity. Both are needed.
More importantly, it is within the context of this framework can we begin to understand the place of impact investing (as well as venture philanthropy) and what it might mean for nonprofit organizations. When managers do not make the distinction between revenue and investment, problems are created not just in the organization’s ability to accurately judge performance, but it also hinders investor’s ability to understand if they are funding effective or ineffective nonprofits. Unless this issue is addressed, nonprofits will not be in position to take advantage of impact investing.
Finally, nonprofit organizations must understand the difference between revenue and investment in order to attract different investors at different stages of organizational growth. This is important for nonprofit organizations because impact investors are already making distinctions between funding more risky, impact-first phases (scaling up and growth) versus less risky, finance-first phases. This can only be done with the separation of revenue from investment and active monitoring of whether the organization can self-sustain on surplus revenue. In order for nonprofits to take advantage of impact investing, they must make a distinction between revenue and investment.
The success of impact investing is not ordained. Impact investing is relatively new and much has to happen for it to reach it’s potential and promise. Nonprofit organizational accounting practices need to distinguish between investment and revenue to ensure that restricted funds, as well as investments, are used for their intended purposes. While investee organizations will be accountable for their performance (or lack thereof), investors will not inadvertently fund low performing organizations, and the impact investing industry, as a whole, will prosper. While impact investing will never replace philanthropic donations, it is an undeniably important complement. The continual evolution of this marketplace will have exciting implications for nonprofit organizational management for years to come.
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