Best Practices for Nonprofit Financial Health, Part Two: Smart Nonprofit Business Models

In a three-part series on “Best Practices for Nonprofit Financial Health,” Alice Antonelli, Director for Consulting at Nonprofit Finance Fund (NFF), shares answers to some of the most commonly asked questions about nonprofit finance along with best practices for financial health in the social sector. Her first post explores the “Top 3 Measures of Financial Health,” and this second blog highlights practical considerations for smart nonprofit business models.

First, what does the term business model mean? NFF defines the nonprofit business model simply as how an organization makes and spends money in service of its mission.

The business model is comprised of:

• Service, which a nonprofit performs according to its mission and by which it impacts its community and/or constituents
• Revenue that supports mission and pays for the organization’s cost structure (as reliable and repeatable income)
• Expenses that should not only reflect program and capacity (i.e., infrastructure and administrative) expenses, but also the ‘full costs’ associated with implementing programmatic activities (i.e., funding balance sheet and other long-term needs)

We often use the term business model to describe an organization's sources of funding and/or major costs. For example, we might say that “The organization's business model is heavily reliant on government contracts” or “The organization's business model includes facility-management expenses to generate rental income to subsidize program delivery.”

As in my previous blog about the Top 3 Measures of Financial Health, I will use the example of a small performing arts center, the Drama Queen (DQ) Theatre, to help illustrate these ideas. DQ Theatre’s business model is comprised of:

• Service: it provides performances that are accessible and culturally relevant to the community;
• Revenue: ticket revenue from performances, subscription income, and contract revenue that pays for outreach programming, along with a few foundation grants and donations from individuals; and
• Expenses: primarily consisting of costs from renting a facility, hosting performances (paying performers and their travel and lodging) and staff.

NFF believes that a smart business model is one in which regular, reliable revenue is sufficient to cover the full cost of doing business, including funding longer-term balance sheet needs. A dysfunctional or "broken" business model is one that is not able to generate sufficient revenue on a consistent basis, causing the organization to run deficits year after year.

Nonprofit business models are usually subsidy-dependent. Nonprofits, by nature, tend to provide services or programming that cannot sustain the organization through direct pay (or in the case of DQ Theatre, through ticket and subscription revenue), unlike business models in the for-profit world where services generate enough revenue to cover all costs. In the nonprofit sector, a healthy business model often includes at least one source of financial subsidy to support its mission-related activities; the most common is fundraising. Here are two examples of nonprofit business models, one in which there is no earned revenue (a homeless shelter), and one in which there is a variety of earned income (such as our example of DQ Theatre). Both need subsidy, but different amounts and types.

• A homeless shelter provides food, shelter, education, and/or medical care to people who cannot pay for it themselves (the shelter does not charge a fee for the services they provide). Third-party payers such as foundations, government, and/or individual donors are necessary to subsidize services provided. Otherwise, services would not be able to continue.
• DQ Theatre sells tickets to performances, subscriptions for the season, and may charge schools for outreach programming; however, even though the organization is garnering all this earned revenue, it most likely will not be enough to cover expenses. Grants from foundations and donations from individuals are necessary for the theatre to subsidize its programming.

Other revenue-generating subsidy activities may come in the form of other earned-income strategies, for example, fee-for-service programs, a thrift store, or a facility rental. The subsidy business may be related to the mission (e.g., running a food concession stand at DQ Theatre) or unrelated (e.g., subleasing the space for weddings and parties at DQ Theatre). A subsidy business should be evaluated on the merits of its contribution both financially and programmatically to the nonprofit, as the ultimate purpose of the subsidy business is to help fund the nonprofit's mission.

In these times of unprecedented disruption, what are some of the challenges that affect (even the smartest) nonprofit business models? And how can we mitigate them?

In NFF’s 2015 State of the Sector Survey, 76% of nonprofits reported an increase in demand for services, and 52% reported that they could not meet demand. In these tough times, both nonprofits and for-profits are subject to disruption in their core businesses, but the nonprofit also may suffer in its subsidy business as well. For example, a social services agency may experience increased demand for services, yet less funding from government sources that pay for those services. There are several strategies that nonprofit leaders can employ, but for the most part they all boil down to creating surpluses by increasing earned and/or contributed revenue, and/or trimming expenses. Nonprofit leaders will want to re-examine their business model and ask themselves, can they continue under a “business as usual” scenario, or do they have to make changes because they have entered into a “new normal?” These are some of the toughest conversations that nonprofit leaders face, and sometimes involve looking at programming adjustments to balance money and mission. Modifying or changing a business model may necessitate a new way of thinking (and probably a little soul searching), outside expertise to investigate and test different scenarios, and sometimes significant investment in order to retool and adapt. Once business model repositioning is underway, nonprofit leaders will want to make sure that they budget for full costs and intentionally build reserves to mitigate future risk and tough times.

Next up is Part 3: Understanding Full Costs