10/07/2013 11:09 am ET Updated Dec 07, 2013

The Social Impact Movement: Designing Nonprofits to Succeed

Recently, I raised an awkward question: "Are Nonprofits Designed to Fail?"

As I wrote, for all the good work a nonprofit may do, it's often hard to tell if a it's really making a difference: fixing the underlying problem, rather than forever treating symptoms.

Now almost by definition, the challenges that nonprofits tackle are hard ones. After all, the rest of society has failed to meet them. And some non-profits do of course succeed.

But like an increasing number of other observers, I suspect that much of the nonprofit sector suffers from structural flaws that can make success much harder than it needs to be.

Here I discuss two of the biggest such flaws, and explore ideas for fixing them. These ideas come from a growing movement towards social impact, which seeks to reinvent our models of how nonprofits can work.

Flaw #1: Backwards incentives -- success is punished.

Consider a company that sells food. The more it sells, the more money it makes. Success is rewarded.

Graphic: for nonprofits, financial incentives can work against productivity
But now consider a nonprofit that advocates for healthy food, say by trying to get it into school cafeterias. What happens as it succeeds? It may get less money -- why donate as much to help fewer school kids? Further progress gets harder and harder.

And if the nonprofit achieves total success, so that all schools serve healthy food? It may very well go out of business.

Conversely, if a nonprofit reaches more clients, there's no guarantee that funding will increase -- it may just have to do more, with no more money.

In the private sector, productivity growth is the engine of wealth creation. For a nonprofit, it can lead to contraction, and even extinction.

Backwards incentives also make it hard for nonprofits to work together in order to achieve larger goals.

Such collaboration is common in the private sector, even though that sector is driven primarily by competition. That's because economies of scale can mean more customers overall, and hence more money for each collaborative partner. So we see joint ventures, industry alliances, shared platforms, mergers, and acquisitions.

But in the nonprofit sector, these are less common. Nonprofit collaboration, often known as collective impact, is recognized as a powerful productivity booster. But collective impact projects often get bogged down in months or years of meetings, conflict, and trust-building exercises.

I suspect the real difficulty is the underlying economics. When revenue doesn't grow with productivity, collaboration looks like a zero-sum game -- that is, a lot like competition.

Corporations, don't need trust-building exercises -- or trust, for that matter. They have contracts.

Let me emphasize that despite all this, most people working at nonprofits do want to succeed. But instead of being motivated by their financial incentives, they have to fight them.

What to do?

If the financial incentives are backwards, why not realign them? Public sector innovators are experimenting with ways to do just that.

For example, some governments are using a new funding mechanism called a social impact bond to pay nonprofits to tackle homelessness and other persistent challenges. A social impact bond rewards success. A recent Harvard Magazine article explains:

If the project achieves its stated objectives, the government repays the investors with returns based on the savings the government accrues as a result of the program's success. (Taxpayers also receive a portion of the budget gains in the form of freed-up public resources, though the investors may need to be fully paid first.)

The design of social impact bonds suggests that we could take seriously the declaration by some nonprofits that their goal is "to put ourselves out of business." What if there were rewards for that outcome? The successful nonprofit could then move on to another challenge, which is in fact what the March of Dimes did after winning against polio.

Another notable example of financial innovation is shared value, developed by Harvard business theorists Michael Porter and Mark Kramer. Shared value realigns incentives by expanding the concept of profit.

In a 1999 Harvard Business Review article, they noted that "The presumed trade-offs between economic efficiency and social progress have been institutionalized in decades of policy choices." They argue that such trade-offs are not necessary:

...shared value... involves creating economic value in a way that also creates value for society by addressing its needs and challenges. Businesses must reconnect company success with social progress. Shared value is not social responsibility, philanthropy, or even sustainability, but a new way to achieve economic success. It is not on the margin of what companies do but at the center.

It's still too early to judge the potential of both social impact bonds and shared value. But many in the public sector had long ago concluded that backwards incentives were just part of the way things are. Thanks to innovations like these, that conclusion now looks quite a bit less inevitable.

Flaw #2: Conflicting market signals -- customers are not payers.

There is little in this world that attracts more obsessive attention than the willingness to pay for it.

A loving mother springs to mind. Successful marketers come a close second.

To marketers, payment is not just money. It's a powerful message about what you want or need, which is known as a market signal. Responsiveness to market signals is a big part of why the free market is so powerful.

But in the nonprofit sector, it's seldom the customer, or client, who pays. Instead, it's usually a donor, whether that be an individual, a foundation or a government. Unsurprisingly, since their survival depends on doing so, nonprofits pay obsessive attention to donors.

But that means less attention to clients, which can easily distort and diminish the services those clients receive.

For profit business model: attention is focused on the customer
A for profit business can focus on its customers.

In the private sector, if customers prefer blue to green, they're going to get blue. But in the nonprofit sector, if clients need blue, and donors like green, what gets delivered is likely to be some shade of teal.

Nonprofit business model: attention is divided between donors and clients
A nonprofit has to divide its attention between donors and clients.

Many grants to nonprofits specify how services should be delivered. So, many nonprofits chase grants by modifying their plans to suit, sometimes straying from their missions.

This flies in the face of responsiveness to market signals. It's like allowing a corporation's investors to design its products, or running an economy based on a five-year plan.

What to do?

Some free market radicals think the answer to the "customers don't pay" problem is obvious: customers who don't pay don't get served. Hence the (unconscionable, in my view) attacks we're currently seeing on food stamps and other programs that save vulnerable people from destitution.

But charity exists precisely because there are some customers who can't pay.

A couple of recent innovations rethink customers and market signals.

One is social entrepreneurship. We might think of it as steering more attention to clients by making them more customer-like.

For example, microfinance: maybe customers can't pay now, but what if they could in the future? A microfinance program gives tiny loans to entrepreneurs so they can grow businesses for the benefit of the whole community. The entrepreneurs pay the loans back from their increased earnings.

You might think of microfinance as the opposite of a leveraged buyout -- a leveraged buy-in.

Another approach is high impact philanthropy. Impact philanthropists don't want to give money and just trust that it will do some good. They want to see results.

In effect, they're customers who buy change, along with the satisfaction that comes with knowing they helped make it happen.

Treating donors as customers formalizes what many non-profits are already doing. What then does that make the clients?

Resources. These resources are converted from one form -- suffering -- to another -- not-suffering, yielding the change the nonprofit "sells" to impact philanthropists.

Graph of suffering diminishing over time
A key part of impact philanthropy is the use of metrics that measure impact, not just activity: not how many clients were served, for example, but what change happened in those clients' lives.

Traditionally, charities were rated according to how transparently and efficiently they spent money on programs. They could get the highest ratings by starving themselves of overhead (which often reduced their effectiveness) while giving little indication of what was really being accomplished.

But that's changing. Many impact-oriented donors are turning to newer ratings services like GiveWell and AidGrade, which give high priority to measurable outcomes.

Now I don't blame you if you think this talk of customers, resources and metrics sounds a little chilly. Many are uncomfortable with the whole idea of applying business models to the profession of service, fearing we might lose sight of unquantifiable human elements like compassion and, well, charity, whose root meaning is "love."

I understand, and I believe we need to keep the heart in all this.

But I'm also OK with some chilly analysis, if it leads to doing real good in the real world.

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