Competition in the Non-Profit Sector Part IV
The amount and manner of competition among not-for-profits have been
changing, and the stakes are getting higher (please see previous
installments of this series in the archives section).
Financial, political, and bureaucratic factors have coalesced into a
morass that is threatening large and small organizations alike. In
short, many nonprofits are finding themselves in a position where they
are expected to do more and more, with less and less. Many
organizations have cut back their services. Some have ceased to
exist.
Solid numbers regarding the dissolution of nonprofits are difficult to
come by. The primary source of financial data in the nonprofit
sector in the United States has been Form 990. However, if an
organization stops filing a Form 990, one cannot assume that it was
because it ceased to exist due to the aforementioned pressures.
Indeed, some not-for-profits voluntarily close their doors because they
have successfully achieved their missions and the need for their
services no longer exists. Also, one agency might have merged
under the banner of another and disappeared in name only.
Furthermore, organizations might dip beneath the dollar threshold at
which a Form 990 is required. These continue to function, but are
beneath the radar of the federal government.
Still, the anecdotal evidence is clear. Virtually everyone in the
field with whom this writer has spoken, regardless of the US State in
which they operate, is employed by or knows first hand of an agency that
is on the brink of extinction. These observations cross many lines
of funding and mission. Even those with strong endowments have
suffered (due to the “dot com bust” and a stagnant economy).
As organizations compete for the limited resources, some will survive
and some will not. Which will be winners and which will lose?
This paper examines some of the existing thinking on this subject, and
offers some thoughts that might help develop models that will serve as
predictors and warnings.
Efforts to determine which organizations are at risk for failure have
been underway in the for-profit sector for many years. This type
of research was essential to those who considered whether or not to
invest money in a particular business. Attempts to adapt those
methods to the non-profit arena lagged far behind the initiation of
their use in for-profits. This is, perhaps, because the concept of
“investment” in a not-for-profit is in some ways an oxymoron. That
is, by definition a 501c(3) entity cannot distribute “profits” to its
“investors” in the traditional sense.
This does not mean that it is unimportant to have such models for
nonprofits. It just means that the recognition of the need came
late, so there is much catching up to do.
Donors want to know that their contributions are not being thrown into a
bottomless pit.
Those who purchase bonds issued by nonprofits need to be assured that
their investment will pay off.
Government agencies and others who contract with not-for-profits need to
know that the organizations can fulfill the terms of the agreements.
Prospective and current employees need to evaluate their degree of job
security.
Those who make decisions within nonprofits would benefit from the
guidance of accurate models as they engage in risk management.
Indeed, as argued by Reiser¹, it is this writer’s position that it is
important for each and every member of a nonprofit to participate in the
oversight role. In doing so they require an understanding of what
constitutes undue risk. A sound model of the behaviors and
circumstances that create threats to a nonprofit’s survival can be a key
component of such a comprehensive system of oversight.
So, which analytical models are reliable and useful?
An excellent paper on the matter was done by Keating, Fischer, Gordon
and Greenlee². They examined the methods of Altman, Ohlson, and
Tuckman & Chang in depth. Of these, “…the Ohlson model performs
substantially better than the other models individually or combined…”.
However, “Despite its superior explanatory power, the Ohlson model
actually classifies more firms incorrectly than the naïve model” which
is simply a prediction that none of the organizations in the study will
become distressed. In its summary, the paper reports:
“While the existing prediction models provide insight into some
indicators of future financial vulnerability, they are not very
effective in distinguishing the particular firms that will experience
distress. Therefore, researchers and practitioners are not
encouraged to use any of these models for purposes of default or
bankruptcy prediction.”
The Ohlson model measured such things as working capital-to-total
assets, liabilities-to-current assets, net income-to-total assets, total
liabilities-to-total assets, a scaled change in net income, and it also
included size and cash flow variables. Ohlson designed his model
for use in a for-profit setting. Therefore, Keating, et al
modified some variables to make the model more relevant to the
not-for-profit environment.
Next, they supplemented the variables from the models they studied with
two large categories that might be related to a non-profit’s viability:
systematic and firm specific. Systematic refers to macroeconomic
factors such as regional and industry factors. Firm-specific
factors include such things as fundamental accounting based signals,
earnings on investments, etc.
Keating et al then attempted to improve upon the above by adding two
additional variables: reliance on commercial revenues and
endowment sufficiency. They hypothesized that there was a direct
relationship between these and the viability of an organization.
With these additions, their measurements showed some improvement in the
predictive ability of the model. But accuracy and reliability were
still insufficient for use in decision-making.
In a paper prepared for a presentation at the 1998 Annual Meetings of
the Association for Research on Nonprofit Organizations and Voluntary
Actions, Mark A. Hager encouraged the exploration of a different
approach³
He found methods such as those described above to be insufficient and
encouraged investigation of idiographic approaches to causation
He asserted that “Change in organizations is a dynamic process that is
not typically captured well by models that investigate the patterns of
covariation of organizational characteristics in a population of
organizations. Rather, methods that consider the roles that
discrete events play in the unfolding of organizational life histories
may be more useful in describing and understanding organizational
change”.
The method he describes involves the study of a “strategic narrative”
using Heise’s (1989) event structure analysis (ESA). This entails
the development of a narrative using the skill of an interviewer and the
judgment of the interviewee. ESA is then utilized to delineate the
sequence of events that led to the outcome, and the causal relationships
among those events.
Theoretically, this method might be honed to a point where it can help
to identify organizations early in the process of their demise.
However, it depends upon accurate memories, sound judgment, and
forthrightness in those being interviewed. Similarly, the
interviewing and documentation techniques would require a significant
degree of consistency. While all of these things can be difficult
to measure, and impossible to completely assure, this method appears to
be a valuable adjunct to more traditional measurements of the
correlation among variables. As such, this historical information
could be valuable to decision makers for whom it is important to know
when a nonprofit is in distress, and how to best intervene.
This writer considers three other factors, which were not specifically
mentioned in the aforementioned studies, to be critical in the
assessment of whether or not an organization will become distressed.
These are:
1. The amount, quality, stability and political connectedness of
competitors
2. The morale, ability, and stability of the organization’s human
resources.
3. Legal/Regulatory status
Competition has become very fierce (please see previous articles in this
series). This results in a thinning of the herd. However,
even if an organization is in financial distress, they might still
survive if they are the only game in town. On the other hand, even
a small amount of financial difficulty might cause political enemies and
competitors to smell blood and go in for the kill if the organization
has made significant enemies.
Human resource issues must be a consideration, but models reviewed
during the research for this article have, at most, given this only
passing mention. In fact, these can make or break an organization.
This writer has witnessed examples of organizations whose staff
essentially enabled them to continue to function effectively when, by
any other measure, they should have ceased to exist. In one
instance, an organization’s primary customer became unable to pay its
bills. The nonprofit had virtually no liquid assets, and almost
immediately became unable to meet its payroll expenses.
Nonetheless, all of the staff members were fully dedicated to the
organization, its leadership, its mission, and its clientele. The
employees continued to work without pay for several weeks until the
money owed to their organization was forthcoming.
Of course, the opposite has been true as well. When a significant
number of staff members arrive at the conclusion that the leaders of the
organization are not operating in the employees’ or the client’s best
interests, services can deteriorate quickly. This has led to a
landslide of other problems for some organizations. In some cases,
it has been a key factor in the destruction of organizations.
Finally, poor legal or regulatory status can quickly cause the demise of
any business. Many nonprofits operate in environments that are
regulated very heavily. The loss of a license to do business will
immediately interrupt services, severely impact financial health, and
cause a loss of confidence in management. Legal issues can be just
as damaging. An organization facing a major lawsuit might lose
large sums of money in the verdict, or via a settlement. Even if
the organization wins a lawsuit it can face daunting legal fees.
In assessing which organizations will continue to exist, and which will
fold, the above-described methods should be applied to assess not only
one’s own organization but its competitors as well. This
information together with indices geared to measure and predict the size
of the market can provide sound bases for decision-making.
There is nothing that can completely substitute for doing research
yourself of the sort described above. However, if one wishes to
use a fairly quick and easy indicator as a warning bell, one is often
available for larger organizations: bond ratings.
For instance, Standard & Poor’s has its own formula for gauging the
health of human service providers. According to a paper done by
John Fargnoli and Martin D. Arrick the “Major factors in Standard &
Poor’s Rating Services review include:
Service essentiality;
Provider assessment;
Management quality;
Financial analysis;
Funding agency relationship; and
Pledged security and legal structure.”4
Fargnoli, of course, does not give specific details of techniques
utilized to judge each of these items. The weighting assigned to
each item is absent as well. In addition, the frequency with which
an organization is rated is not clear. However, he provides
sufficient description to conclude that the basic logic behind the
ratings is sound. If S&P drops the bond rating on your
organization, it is not something to merely be explained away at a board
meeting. It is useful information in forming an assessment of your
organization.
SUMMARY
So who will be the winners and who will be the losers in this rough and
tumble competition for shrinking resources? In general if all else
is equal, large companies will do better than small ones. They
have the ability to spread shockwaves that hit a particular sector of
their market over a larger area, thus diminishing the intensity of the
impact on any single point. They also can have the benefits of
economy of scale. However, there are two main exceptions.
Small operations will often beat larger organizations if the larger ones
are new to the geographic area, and more importantly, to the people who
are the decision makers in that area. Hager, Galaskiewicz, and
Larsen addressed this matter in detail in Structural Embeddedness and
the Liability of Newness Among Nonprofit Organizations; Public
Management Review, © 2004 Taylor and Francis, Ltd;
http://www.tandf.co.uk/journals. One should never
underestimate the impact of personal relationships. The other
exception is diseconomies of scale. In this situation, put simply,
the organization is so large and inefficient that it cannot get out of
its own way.
Finally, if this writer were to compare two competitors and attempt to
choose which was more likely to fail, he would look for the following:
A high debt load with poor liquidity
A small or nonexistent endowment
Routinely drawing clientele from the margin, rather than the core of
the market
A culture of fear among employees
Alienated funding agencies
Poor communication among decision makers
Serious legal or regulatory issues
“Ponzi scheme” long-term finance planning (in which it will only remain
solvent with growth – please see previous article
here)
Upper level management with an “us vs. them” approach to managing their
own personnel.
High staff turnover rates
Complete knowledge of what causes organizations to fail is impossible
due to the myriad forms and settings in which they exist. Even if
a perfect model was available, it would not prevent the loss of many
nonprofits in the current environment.
However, it is the hope of this writer that a better understanding of
the processes that lead to organizational distress will help to reduce
unnecessary loss of valuable nonprofit entities. Therefore, much
additional research is encouraged and managers are urged to acquaint
themselves with the body of knowledge that is currently available.
Click here for this article in pdf format
¹Dana Brakman Reiser, Enron.org - Why Sarbanes-Oxley Will Not
Ensure Comprehensive Nonprofit Accountability, Brooklyn Law School
Public Law and Legal Theory Research Paper Series, Research Paper No. 6;
March, 2004
²Keating, Fischer, Gordon, and
Greenlee, Assessing Financial Vulnerability in the Nonprofit Sector,
July 2004
³Mark A. Hager, Event Structure Analysis as a Tool for understanding
Organizational Life Histories, completed under sponsorship of the
Nonprofit Sector Research Fund, November 1998
4 Primary credit: John Fargnoli; Secondary credit: Martin D.
Arrick; Public Finance Criteria: Human Service Providers, Ratings
Direct, Standard & Poor’s, October 15, 2004