Nonprofit Income Diversification: A Cautionary Tale

In 2014 one of our clients derived about 25% of income from one Federal pass-through grant. This grant substantially plugged the shortfall between the program service fees they charged to clients and their costs to provide the program.

That year the notes to their audited financial statements cautioned (details changed): “The Organization received substantial support ($XX,XXX) from [Local Government Agency] and other contributors. A reduction in the level of support from grantors and contributions may affect the Organization’s activities.”

Two accounting observations:

  • Audited financial statements include extensive notes at the end. Read the notes. They can be quite interesting and enlightening.
  • FASB ASC 275-10-50 requires a note to the financial statements to disclose “risks and uncertainties,” including concentrations in revenue from a customer, grantor, or fundraising event that “make the entity vulnerable to the risk of a near-term severe impact.”

In the following year, unfortunately, the grant was not renewed. That year the notes to the audited financial statements included the following statement (details changed): “The Organization’s contract to provide services with [Local Government Agency] ended….due to discontinued federal funding. The lost revenue has yet to be replaced. Management believes it will recover the deficiency with concerted fundraising and grant awards.”

Now the disclosure of “risks and uncertainties” turns from the potential of losing a significant funding source to the risk of not being able to replace it. The note also describes management’s plans to recover. (Raise more money!)

Unfortunately, the organization was not successful in raising new funds to replace the lost Federal pass-through grant. After about two years of substantial losses, the organization nearly closed. They were forced to lay off staff and severely curtail operations.

Is the moral of this story to diversify income? Yes and no!

First do an excellent job with the income sources you have.

The note to the financial statements in the story above does not say exactly why federal funding was discontinued. Did the federal program end? We know awards by the same federal program were made to other area organizations that year.

Was the organization not competitive in terms of program delivery capability? Was an error made in the application process? Somewhere there was a breakdown between the organization and the government agency. Grant applications can be nitpicky in their requirements. One small misstep could have disqualified them from being funded.

Perhaps better quality control over the federal grant process would have made the difference. A 2003 study by Bridgespan Group found that successful small organizations were actually less diversified in their early stages of growth. They focused on doing an excellent job with a few funding sources.

Costs of Diversification

In our story above, perhaps the organization’s staff was stretched too thin. They were involved in the delivery of program services over multiple counties; they held a major annual fundraising event; they managed the application and reporting for a federal grant; plus they cultivated annual donors, major gifts and private foundation grants. Even within program service operations they were diversified — they managed individual clients and institutional clients, each with different needs.

If they had diversified into one more funding source, everyone may have had a complete breakdown!

What if they had analyzed what was working, what was not working, where they were vulnerable, and made adjustments accordingly? For example, institutional clients paid full market price for services. Each institutional client they served added income to their bottom line. Individual clients, in contrast, paid a highly discounted rate. Each individual client they served cost money, which meant they had to raise money to offset the loss. Perhaps a focus to build up institutional client business and better manage individual client business to hold losses to a manageable level would have helped them become more financially sustainable.

In the contribution income area, perhaps they could have consulted with a fund development specialist to help them prioritize fund development efforts. Perhaps the annual fundraising event required too much staff time for the income it brought in. Perhaps there were ways they could have become more effective at raising individual contributions.

The point of income diversification is to help the organization become more financially sustainable. This organization already had several diversified sources of income to balance a mission-centric, but money-losing, program. Instead of diversifying income even more, perhaps the organization needed to re-balance or even reduce their existing portfolio of program services and income producing activities to achieve the right balance of diversification.

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