Loss Leaders

Last month I was signed up by a colleague to give a lecture to a class of graduate students at New York University studying arts management, all of whom were intending to pursue careers as managers and administrators in cultural institutions, and most of whom already had some experience in line management under their belts. My session was slotted into the finance elective.

They were, as I had been forewarned, bright and engaged and I thought I would play the Ancient Mariner and use the opportunity to drive home some fundamental and hard-learned truth that, if sufficiently memorable in its delivery, might serve my captive audience well in their professional lives. My "insight" was that nonprofit cultural organizations are inherently loss-making. This is so stupefyingly self-evident, I suggested, that we forget that its implications permeate every aspect of the financial dynamics and culture of arts organizations.

There is an inescapable tension in the short term between pursuit of mission (and the programs that support an organization's mission) and maintaining financial viability. All dynamic, mission-driven nonprofits live in the force field created by the tension between money and mission. The force field grows more powerful the greater the urge to expand programming. And given that there is usually a large gap between an organization's mission and the part of that mission met by current programs, the urge to grow is usually very powerful.

However, growth usually cannot be funded by retained surpluses — simply because generally there aren't any! Growth therefore needs to be funded externally. But debt-funded growth requires repayment of both interest and eventually principal and therefore assumes either that the investment will generate a positive rate of return or, more usually, that it will attract philanthropic funding to meet these repayment costs. Equity investment, per se, is not an option for nonprofits, although they may have opportunities either to create for-profit subsidiaries or strategic alliances with for-profit organizations that provide vehicles for investors. But equity investment, too, is premised on a positive rate of return on capital employed.

The primary source of funding for growth is therefore either contributed income or income from reserves and endowments that have themselves been created through contributed income. However, unless nonprofit arts organizations can articulate — and funders embrace — the idea that growth requires investment, and that the full rather than marginal costs of growth need to be covered by these sources of contributed income, the impact of growth is generally to stretch organizational and financial capacity more and more thinly...leading to systemic under-funding of such areas as facilities maintenance, funded depreciation, working capital, staff development, competitive salaries, or training — all of which are required to support programs.

The reasons we tend to turn a blind eye to this simple logic run very deep. One is that, as a whole, the nonprofit sector relies heavily on the skills, energies, and enthusiasms of its executive and non-executive leadership. This reliance on leaders is often formidable — so formidable that it generates a belief that sheer energy, will power, stamina, and enthusiasm can overcome all obstacles, and that where it does not, failure is rooted in some sort of personal failing in the leadership. The idea that an inappropriate capital structure can somehow subvert an organization's ability to meet its objectives can seem overly deterministic, fatalistic even.

Another reason is that, as a whole, the sector has tended to focus on organizational capacity building rather than financial capacity building. The sector needs both. No amount of attention to, say, strategic marketing, is going to make things come right if your organization is so fundamentally short of working capital that you cannot lift your head above the problems of next week's payroll. Indeed, inadequate working capital is probably more corrosive to organizational effectiveness in the nonprofit sector than any other single factor. It means that the short term crowds out the longer term and that cash flow considerations dominate planning, with creditor management absorbing the time, money, and emotional reserves that are needed for longer-term planning.

The ability to take informed risks — essential to the realization of the mission of most nonprofit cultural organizations — is similarly compromised, with the result that either conservative programming dominates (what is less risky and most likely to generate cash) or each artistic risk involves the concomitant financial risk of “betting the house” on a successful outcome, conducive to graying hairs and ulcers for all involved.

Raising contributed income in parallel with program growth and sufficient to fund the full difference between income and expenditure is extremely tough. The easier costs to cover are direct program costs — more visible, more attractive, more obviously mission-related. Fixed costs tend to get drafted around, talked down, and deferred, not least because organizations wishing to present themselves to potential funders as efficient want to maximize, at least on paper, the ratio of direct to indirect costs.

It takes determined leadership — with a long-term view of the organization, with a good knowledge of an organization's cost base, and with a commitment to institutional stability — to ensure that growth in programs does not, over time, sap an organization. Without the knowledge, the will to act on that knowledge, and a sophisticated or receptive funding community, a cultural organization will ‘hollow out' as its programming grows, the balance sheet will weaken, and short-term cash-flow issues will come to dominate long-term vision.

For this reason, many cultural organizations are something of a disappointment for the well-intentioned, competent, highly motivated people they recruit. The impetus to programmatic growth — spurred both by the ever present gap between program and mission and by sheer entrepreneurial drive — tends to leave institutions increasingly hard-pressed, under-managed, under-staffed, “de-skilled,” ill housed, foreshortened in their horizons, and generally ground down.

In order to expand programming effectively, nonprofit cultural organizations therefore have to expand their financial capacity — not willy-nilly, but in specific ways that support their programming ambitions. Any given expansion in activity can be funded in a variety of ways (through different combinations of contributed and earned income and debt), and these will make different demands on an organization's capital structure (on working capital, for example, or on the organization's reserves, lines of credit, or longer-term debt instruments). Rarely does “spontaneous” unplanned growth have a positive impact on an organization's capital structure. Planned growth in programming requires planned growth in financial resources.

What, asked the NYU students, can one realistically do in the face of these rather dismal and deterministic observations? I would suggest the following:

• Encourage your organizations to look at the impact on their balance sheets as well as on their cash flow when considering programmed expansion;
• Encourage them to analyze and articulate the full cost rather than the marginal cost of program growth and to generate cost information in a format that allows this to be done and communicated effectively to the outside world;
• Encourage them to think about and articulate the requirements for institutional growth in parallel with program growth;
• Encourage them to include goals for capital structure and investment as part of their strategic planning process;
• Encourage them to remember that the reason they are nonprofit organizations is not just because they are mission driven. It's not just because their mission is valued by society. It's also because the pursuit of mission is an axiomatically unprofitable activity.

What is true of individual arts organizations is collectively true of the sector as a whole. As the nonprofit cultural sector itself expands, and in the absence of retained profits (or, more properly, surpluses) to fund that growth, it needs either to increase contributed income proportionately, or to develop new sources of ancillary earned income, or to secure more fiscal concessions. The scope for the last two of these is limited. The alternative is systemic, and progressive, financial weakening of the sector over the longer term as growth in resources fails to keep pace with the aggregate need for them across the expanding sector.

Ultimately, graduate recruits cannot do much about this. Arts leaders can and should resist the temptation to try to trump capital with willpower. But a responsibility also lies with the funding bodies that have a long-term commitment to the sector and its long term health — grantmakers in the arts. Long term funders are probably best positioned to ensure that programmatic growth, where it is implicitly (and often explicitly) encouraged by the funding ecology, is also adequately funded; that the corrosive temptation to fund only the marginal costs of programming is resisted; and that those funders engaged by specific programs but with a less profound commitment to the sector are encouraged to understand that programs by themselves do not a culture make; and that what might appear to be efficient funding in the short term not be allowed to weaken the sector in the longer term.

Adrian Ellis is a principal at AEA Consulting, a company that specializes in strategic planning for cultural organizations and their funders. The thinking that informed this article has been stimulated by work he is undertaking with the Nonprofit Facilities Fund, New York, on integrated approaches to capitalization.