Working in the Dark

In 2012, I became the CEO of a start-up social enterprise (501c3) in San Diego. At the time, I was a life-long private-sector entrepreneur; this organization, called Mission Edge, marked my first foray into the nonprofit world.

At Mission Edge, we help nonprofits build capacity in their “back office.” We charge below-market (subsidized) fees to facilitate the sharing of expert resources across multiple organizations, while working to improve their organizational effectiveness. And after more than 20 years in business, I can honestly say that this endeavor has been by far the biggest challenge of my career—not because of market demand (there is plenty of need for what we provide), or a shortage of talent (we have found many passionate and skilled employees), or even pricing (in most cases, our clients can afford our discounted rates). Rather, the challenge lies fundamentally in the way the social sector is capitalized.

As with most nonprofits, the fees we charge don’t cover our fully burdened costs, and thus we often find ourselves in the same position as many of our clients—struggling to secure the basic operational capital necessary for growth. Capital fuels all markets and sectors—public and private—and the way we allocate capital creates the incentives that drive behavior. In the private sector, investment flows to those who prove they have the best chance of making a return, and thus companies are focused on tangible (and shareholder) value. It’s an effective—if imperfect—system for creating the incentives that drive value for consumers and wealth for those who take risks and create innovation.

But these incentives largely don’t exist in the nonprofit sector. Nonprofit organizations work in a market where a large percentage of capital ignores the operational needs of running an organization—people, infrastructure, and technology—and instead rewards programmatic (high-visibility) activities. For many, this obsession with overhead and the resulting “starvation cycle” that nonprofits endure is a familiar topic. But it is critical to understand that it is more than just a fixation on overhead; it also reflects a general aversion to funding innovation and taking risk. When Mission Edge launched in 2012, we could find only one funder in San Diego willing to underwrite our immediate start-up capital requirements; other funders, including community foundations that would be natural partners for our work, declined to take the risk on a new model that, whatever its merits, they saw as unproven.

We also found ourselves struggling with the lack of transparency in the funding process. For most nonprofits, the process is to fill out as many grant applications as possible and then wait by the mailbox to see what money falls out of the sky. Or it is to court your major donors for months, hoping that they will write a check but often not knowing how much it will be, since there is no valuation to ascribe to the “investment” and it’s most often a gift from the heart, not their head. For resource-constrained nonprofits, this lack of visibility into the revenue side of the budget process amounts to a major barrier to operational planning, and leads ultimately to poor resource allocation and rushed decision-making. Our solution has been to focus on rolling monthly cash forecasts that prioritize immediate needs over strategic initiatives that require longer-term capital commitments. It may work to keep the lights on, but it is not conducive to solving problems in the community that require complex, multi-year solutions.

I have come to the conclusion that without a radical transformation in the funding market for nonprofits, creating real and lasting improvements to the social sector is impossible.

First, performance has to really matter. That means tracking outcomes and measuring effectiveness, not just tallying up outputs and activity. While many funders talk about program effectiveness and “outcomes measurement,” most don’t practice what they preach. Too often funders and donors give because they care passionately about the issue or because they like the people running the nonprofit (which is good), but fail to link their support to the hard question: Is what you are doing really working? We need to tie funding needs to real and measureable return on investment, and it is critical that funders shift their incentives to reward organizations that can prove results. Matt Forti of One Acre Fund has written extensively on this topic, focusing on a “cost-per-impact” measurement to determine organizational effectiveness. Importantly, Forti cites the need to change the way ratings agencies are reporting nonprofit performance, and highlights GiveWell as a marked improvement over the traditional overhead percentage metrics of Guidestar and Charity Navigator. It’s a step in the right direction, but we need to do much more.

Second, funding needs to happen in the open. Funders should take a page from Silicon Valley and invite potential grantees in for a pitch meeting; ask the organizations’ leaders hard questions about their solutions; and then compare those solutions against the competition, and provide immediate and constructive feedback. Undoubtedly this process would take more time and resources on the funders’ part. But if funders begin to pool their capital and engage in more joint investments, they can derive economies of scale and potentially empower the best organizations to succeed.

Finally, more nonprofits need to fail. One of the more striking differences between the private and social sectors is the frequency of failure. In the private sector, if your product or service doesn’t sell, you either adapt or you go out of business. Too often in the social sector, nonprofits enter a purgatory where they simply exist to exist. Budgets stay largely flat, and programs contort to get just enough funding to keep people employed. Why does this happen? My experience at suggests that funders are not as disciplined as they should be, and thus don’t insist that performance—demonstrable impact—is the criteria for additional investment. Compassion and passion are essential elements of philanthropy, but they do a disservice to the community when they become the primary reason donors and funders continue to support an organization. While some may believe that even a poorly performing nonprofit adds value to the community—highlighting a social problem, providing some services, and putting people to work—I take a different view. In the nonprofit sector, organizations compete for a finite pool of funding. According to the Chronicle of Philanthropy, charitable giving as a percentage of GDP has been flat at roughly 2 percent since the 1970s—meaning that the share of social sector funding as a percentage of economic activity has not grown, even as our population has exploded from 205 million in 1970 to 315 million people today.

In this zero-sum environment, organizations that “exist to exist” absorb vital resources from the community that could (and should) be applied to the best and most effective models. While this perspective might seem harsh, failure is a vital element of any successful marketplace, and it needs to be much more frequent in the nonprofit sector.

Read more stories by Ken Davenport.