Credit Woes Drive Nonprofit Organizations Into Zone of Insolvency

The nonprofit sector’s noble history of service is woven into our nation’s fabric, setting us apart from the rest of the world. Through the largesse of donors and volunteers, our 1.5 million nonprofit organizations deliver over $1 trillion per year in program services. The breadth of the nonprofit community includes a breathtaking array of subsectors from hospitals to art museums, from universities to professional societies, from homeless shelters to relief agencies, from kids camps to sports leagues. There is not a reader of this publication that has not benefited from the work of the nonprofit community.

Nonprofits have a long tradition of cost effective service, and is generally deemed to provide services at levels that could not be achieved for the same price if managed by government or by for-profit corporations. But that landscape is not even, and subsectors and organizations must be evaluated individually to assess their cost effectiveness, or, if you will, the social return on investment. Numerous studies comparing nonprofit hospitals to for-profit hospitals, for instance, have indicated minimal price differential for comparable services.

As the nonprofit sector matures, market competition, and environmental factors, including the economic realities such as the cost of borrowing come to play. During the past 25 years, the rate of incorporation of new nonprofit organizations has been double that of newly incorporated for-profits. At the same time, there have been disproportionately few dissolution filings of nonprofit organizations. The net result is that more nonprofit organizations are actually competing for customers and for donors. The very notion of market competition for mission driven service organizations has been difficult for nonprofit leaders to comprehend, but it is a critical factor in developing sustainable business models for these organizations.

While there are some well-heeled nonprofit organizations that have succeeded in building a net asset base that may include investments, cash, and real estate, one third of all nonprofits live perpetually in financial distress, and that number is increasing. Nonprofit organizations operating in this financial distress that we call the Zone of Insolvency typically experience reductions and or losses in net on operations, depletion of cash reserve and assets, and often drops in gross revenue from fees-for –service and charitable contributions. Strapped for cash, they borrow to meet cash flow demands, but quickly max out their ability to borrow, which begins a downward spiral of cash flow problems.

Recent reports by the New York Times regarding the sudden increase in cost of borrowing that is stressing the Metropolitan Museum of Art, the Los Angeles County Museum of Art and the Museum of Fine Arts (who each borrow in the hundreds of millions of dollars) reminds us of the credit crisis faced by homeowners with subprime mortgages. These nonprofit organizations, and others like them, are finding that cost of borrowing has skyrocketed, significantly impacting their bottom lines. For the 500,000 nonprofits that have been operating in the zone of insolvency, the current economic conditions, complete with the skyrocketing cost of borrowing, will drive many toward total insolvency.

Given the unique legal responsibilities and liabilities of governing a nonprofit organization in financial distress, prudent board members will focus immediately on their organization’s need for credit, assess the structure and long term rates for loans in place, and gain an understanding of the potential impact of skyrocketing cost of credit. Cash flow management becomes the critical factor for financially distressed organizations with dwindling reserves, and increasing costs of credit, or disruption to ability to borrow can be catastrophic.

As the nonprofit sector matures, dealing with the large numbers of financially distressed organizations will become a major challenge. The realities of the current economy may drive that agenda and force more organizations to deal with this challenge much sooner than anticipated. Organizations in the zone of insolvency have three basic options: aggressively manage a financial turn-around, file for dissolution, or arrange for a merger. When an organization gets too deep into the zone, the likelihood of the financial turn-around, or potential to find an interested partner for merger are greatly reduced, which leaves the tough decision for dissolution. Nonprofit boards and management teams that want to avoid considerations of dissolution should be proactive in today’s environment, and make the painful decisions now to build long term sustainability. A financially strong nonprofit community able to serve the public for the long term is in everyone’s best interest.