Funders Aren’t Investors, They’re Purchasers

Over the last two decades, nonprofit funders have increasingly come to view themselves as “investors” or “venture funders” of the nonprofit organizations they fund. A recent article found that, “Among the Web sites of the 100 largest U.S. foundations, for example, 77 tout that they are involved in some type of ‘investment,’ ‘leverage,’ or ‘venture activity.’” But is it accurate or even appropriate for funders to think of themselves as, and act like, investors?

Ownership of assets and taking on management and ownership roles are the hallmark characteristics of for-profit investors. Yet by law, nonprofit funders are prohibited from taking financial stakes in the assets or revenues of the nonprofits they fund. Additionally, funders rarely demand board seats or voting rights in exchange for funding.

Although funders do not officially serve as owners or principals, they often try to act like owners when they give program-specific grants that impose strict and arbitrary limits on administrative and overhead expenses. This contributes to the nonprofit starvation cycle that ultimately leaves nonprofits desperate for the infrastructure and support that are essential for long-term success and viability.

Funder budget controls also usurp the authority of both a nonprofit’s board and its managers to use funding in the best interests of their organization, and shifts it to an outside funder who owes no duty of care or loyalty to the organization. The end result is a dysfunctional internal governance structure, where actors who are not obligated to act in the best interest of an organization sometimes wield more power over operations and financial dealings than those who are obligated.

Rather than thinking of themselves as investors, funders need to think like purchasers. Economic theory identifies nonprofits as the producers of social goods and the funders of nonprofits as the purchasers or buyers of these goods. Viewing funders as purchasers rather than investors provides a clear rationale for avoiding the nonprofit starvation cycle.

Typically, buyers are not principals or owners of the organizations they buy from. Buyers do not try to dictate how their sellers manage their funds and expenses. Buyers are primarily concerned with the goods and services they receive for their payment.

This is not to say that buyers do not concern themselves with how effectively sellers manage their businesses. Especially when complex or expensive goods or services are involved, buyers conduct due diligence on sellers to feel assured that the sellers can deliver on their promises. The key distinction is that once a buyer feels reasonably assured about the seller’s ability to provide a good or service, the buyer does not demand a contract from the seller that limits the seller’s overhead spending, travel costs, etc. The buyer reasonably assumes that the seller knows how to run their business better than they do, and focuses on ensuring that they receive the quantity and quality of the goods ordered within the desired timeframe.

By removing many restrictions on how nonprofits can manage grant monies, and by abolishing the use of arbitrary and unrealistic measures of overhead ratios, funders can break the nonprofit starvation cycle. By acting like purchasers rather than investors, funders can effectively remove themselves from dictating the operations of their grantees, and a functional governance structure within the funded nonprofits can be restored.

This does not mean that funders should just give out grants without being critical of their grantees’ performance. In fact, the opposite is true. Budget controls in grant agreements undoubtedly originated from the inability of funders to fully trust that grantees would use the money to accomplish what they promised. Thus, in order for funders to feel comfortable about letting go of these budget controls, they need to rely on other measures.

First, funders need to intensify the due diligence phase of the process to identify nonprofit organizations that have an established track record, management team, and capacity to deliver results. Rather than focusing on unreliable overhead ratios, funders need to ask more detailed and informative questions to determine if their grantees can deliver results: What is the track record for results? How solid is the management team and the board of directors? Does the organization have the staff, infrastructure, and resources to produce the results it has agreed to?

The second critical element is the development of clear deliverables for grantees and ways to measure results. As I mentioned, purchasers care first and foremost about the goods or services they receive for the money they pay. Much has already been researched and written on the attempt to measure the outputs of nonprofits, and the attendant difficulties of trying to measure broad and nebulous objectives, such as improving primary education or shifting public opinion on gun control laws. Standardized, objective measures that all funders and grantees across each field of interest can agree upon so far have been difficult to develop, but these elements are essential for funders to push for better results and improved impacts.

Lastly, regulators at the Internal Revenue Service and state oversight agencies need to step up efforts to curb illegal abuses of nonprofit finances. A recent study found that since 1996, nearly $30 million of reported losses were incurred by nonprofits as a result of fraud or misappropriation. Concurrently, IRS examinations of nonprofit filings steadily declined from 1.9 percent in 1996 to 0.7 percent in 2003. Active policing of abuses by oversight agencies are critical to funder confidence about grant monies not being used for illicit purposes and can ease funders’ need to try to control nonprofit spending.

The funder-as-investor model spawned an era in which funders became more focused on the results of their funding efforts, and it resulted in improvements in nonprofit management and performance. However, as an imperfect analog, the funder-as-investor model has also hindered and, in some ways, harmed the efforts of both funders and the nonprofits they support. By refocusing their attention on their intended role as purchasers of social good, funders can continue to push for ongoing improvements in results and performance, and spur a new era of innovation.

Paul Park is the general counsel and secretary of the Cesar Chavez Foundation, overseeing all legal matters related to the Chavez Foundation’s affordable housing, nonprofit radio, after-school tutoring, and conference center programs. Paul previously worked as a corporate attorney for the law firm O’Melveny & Myers LLP, and holds a JD and MBA from the University of California, Los Angeles, and an AB in History from Cornell University.

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