01/15/2015 02:46 pm ET Updated Mar 17, 2015

Nonprofits Are Enterprises Too

Every successful entrepreneur knows that when any enterprise starts up or grows, it needs both revenue and capital: revenue to pay for production of goods and services, and capital to create the platform, the business itself.

But what many people don't realize is that in this regard, nonprofits are no different than for-profits. As a result, nonprofits typically lack equity capital, which makes significant long-term growth painfully slow, unsustainable and frequently accompanied by a reduction in program effectiveness.

A quick primer for those who haven't started or run a business lately: All enterprises need ongoing revenue to cover the cost of producing and delivering goods or services. That revenue doesn't just include cash from sales; it can come in the form of donations of money, labor, materials and so on.

Entrepreneurs also need capital to set up (or expand, refresh or improve) the facilities, processes, departments, skill sets, program, cash reserves and more that it takes to produce those goods and services in the first place. At the beginning it may be friends and family, or the well-known approach of "sweat equity" bolstered by personal credit cards and profound resourcefulness.

Later on, when a business grows, enterprises require additional capital to expand the original setup to meet expanded demand, to make operations more efficient or to create new or improved products or program offerings (or all three). Most for-profits use "retained earnings", but in the nonprofit world of emaciated operating margins, retained earnings may be unavailable, and are generally frowned upon by funders ("If you already have money, why are we funding you?").

Sometimes debt can bridge the financial gap, funding expansion of the platform and creating the uptick in revenue to pay it back. But for many important organizations, the growth trajectory is too unsettled and the path is too obscure to use debt to finance growth, since most loans rely on a fixed schedule of payments over time.

When debt and sweat equity aren't enough or appropriate, owners of for-profit businesses can sell ownership shares or "equity" and use the proceeds to enhance capacity. Moreover, the new stakeholders often bring to bear social and intellectual capital as well as financial, contributing to success by attracting market share, building business relationships, or sharing expertise.

Equity in this form is unavailable to nonprofits, in part because by law nobody can own or directly profit from a nonprofit enterprise. This often sentences vital organizations to difficult, unhealthy or slow growth. Especially when opportunity knocks and additional revenue pours in, organizations struggle with extreme pressure on a too-small production capacity.

Sadly, the highest performing and most promising organizations are often most vulnerable to severe growing pains. Their success means they are the ones most likely to attract more revenue--restricted grants, a dizzying array of government contracts, project funding, an expanded list of willing individual givers.

But in the absence of equity capital to expand the systems and headcount that can serve this heightened demand, promising projects are unsustainable, contracts go unbilled or unfulfilled, and willing funders languish unapproached. Like any enterprise facing uncapitalized growth, nonprofits use other means to respond to demand: exploitation of human capital (i.e. long hours, stagnant pay, reduced benefits, more part-timers and unpaid interns); slow bill payments (and sometimes unpaid lines of credit); poorly maintained facilities and, worst, deteriorating program results. What seemed like a slam dunk suddenly becomes a nightmare of cash flow crises, abrupt resignations, internecine board-staff conflicts and plummeting program results.

Enter philanthropic equity. Just as in the for-profit world, philanthropic equity allows growing nonprofits to handle the inevitable deficits incurred on the way to an enhanced and durable level of operations. It understands that small "capacity building" grants restricted to only the computer system or staff training won't suffice for a comprehensive upgrade. And it acknowledges that the ultimate risk of growth is borne by the beneficiaries.

To make philanthropic equity funding more generally available for the best and brightest of the nonprofit enterprises will require work. Here are some ideas on ways for foundations and givers to proceed:

  • Make sure that any strategic plans you fund include a rigorous business section with the following: competitive analysis in the market, sources of revenue, with projections, and increased operating costs, structural and marginal, for an expanded organization;
  • Remember that when revenue grows significantly, capital will be required. This is counter-intuitive: give more -- not less -- in the form of growth capital to great organizations which are increasing their revenues.
  • Find buddies to fund capital campaigns with you for organizations you care about. Few foundations make grants big enough to get an organization up a three to five year growth curve. Mid-size high performers will need in the tens of millions to make an investment that truly creates sustainability.