May 06, 2011

There's No Penalty for Having Reserves

This is the final in a series of four posts on the subject of nonprofit operating reserves. Earlier posts flagged reserves as a topic that deserves more attention, explained what reserves are and why they matter, and discussed how organizations build reserves.

This post addresses two additional roadblocks to building adequate reserves: the perception among executive directors and board members that nonprofit organizations cannot operate at a surplus (or "profit") simply because they are nonprofits and the impression that accumulating reserves will make the organization appear less deserving of funding.

In essence, the two ideas amount to the same thing: the perception that there's a penalty—either legal or psychological—for building operating reserves. Which is not true.

Or at least it's not for the overwhelming majority of organizations. The U.S. Better Business Bureau's Wise Giving Alliance, which assesses whether national organizations are in compliance with its Standards for Charity Accountability, does state in those standards that charities should "avoid accumulating funds that could be used for current program activities." However, to meet that organization's standards, a nonprofit can't have operating reserves totaling more than three years of current operating expenses.

As noted in earlier posts, most local nonprofits in the Urban Institute study of the Washington region (and in other studies that included other regions) had less than three months of expenses in reserves. Many had less than one month. So most nonprofits (virtually all nonprofits, really) are in no immediate danger of running afoul of watchdog organizations for having too much money in the bank.

Nevertheless, many executive directors and board members persist in the belief that reserves are "bad" or "frowned on." Some also mistakenly believe that nonprofits are prohibited by law or by the IRS or by ethical standards from making a "profit" and that all excess funds must be immediately put into current programs. That's simply not true. What happens to the "profits" (they can't be distributed to owners or shareholders) is what distinguishes nonprofits from businesses, not the ability to turn a profit.

Many executive directors and board members also mistakenly believe that funders and donors expect to see a perfectly balanced budget (or even a small deficit or gap between income and expenses) and that if their budget shows a surplus, they won't look needy enough to prospective contributors.

That's also a misconception, although organizations should use common sense in their budget presentation. For example, a budget that shows a surplus many times larger than the amount of a grant request might indeed raise eyebrows at a foundation.

However, most foundations want to support organizations that are managed well, and small budget surpluses and reasonable operating reserves are both signs of prudent financial management.

I work at a foundation, and I've participated in the grant-making processes of other foundations, and I've never heard anyone bring up excessive reserves as a reason to turn down an organization's grant request. In fact, I'd be willing to wager that more organizations have been turned down by foundations for being too poor and unstable than for being too rich.

However inaccurate these misconceptions may be, they are firmly ingrained into the culture of the nonprofit sector. The result is that far too many organizations operate hand-to-mouth with no margin for error and no ability to cope with unpleasant financial surprises. Ultimately, this is a disservice to clients who depend on organizations for services, employees who depend on organizations for their livelihoods, and communities that need stable organizations that can survive in difficult times.

This is clearly a complicated topic. What started (at least in my head) as a short piece to make four quick points has turned into a series of posts.

Yet for board members who are committed to the financial stability and sustainability of the organizations they govern, I can't think of a more important topic. It's worth taking the time to understand.

Thanks to everyone who has already commented on the earlier posts—your comments helped me finish the series. I'd love to hear more!