Dirk ten Grotenhuis, Managing Director, First Republic Bank
Just as in the corporate world, nonprofits can only provide programs, products or services to people by raising operating capital. But unlike for-profit businesses, they aren’t able to promise funders a financial return on investment or look to future sales profits. So, where should nonprofits look for the capital they need — and what’s the best method for securing it?
There are typically two ways to finance long-term projects: fundraising campaigns or borrowing. Both types of capital resources naturally carry an element of risk. What’s more, since nonprofits are not risking their own assets, but rather those of their constituents, they have a heightened obligation to assess and limit risk by conducting a detailed financial analysis before choosing either option and securing the very best terms possible.
Let’s look at the pros and cons of both options.
Weighing the options
It is essential for any nonprofit to assess financial risks and strengths before determining which method or methods to use for obtaining capital. Two aspects to consider:
- Debt capacity. How much can you borrow? What cash flow do you have to service that debt? What amount of equity would need to be added?
- Fairness of equity. Who will use the facility? Are these constituents the same people who will help pay for it?
Further, when deciding on a financial strategy, a nonprofit’s board should be able to answer the following high-level questions:
- What are the details of this project?
- What’s the estimated cost of this project?
- What’s the projected timeframe for building this project from start to finish?
- What is the fundraising capacity for this project?
- What is our debt capacity, and how much can we borrow?
- Have we established a capital campaign for this project? If so, where are we in the process?
- What is our ultimate goal with this project?
A nonprofit’s board of directors and management team should discuss and know the answers to these questions before deciding which financial strategy to take.
Nonprofit fundraising can come from any number of sources: individuals, corporations, private philanthropists or grants. For a large capital campaign, fundraising typically involves asking for longer-term pledges so that nonprofits can amass as much money as possible upfront. However, if you plan to start a capital project that will take one to two years to complete, then you must find a way to ensure your cash flow is steady enough to cover the construction costs.
If your organization is unable to raise the entire budget in advance due to campaign pledges coming in after the project is completed, then you’ll need to consider additional sources of capital. Because many nonprofits are adept at raising funds for operations at key moments (typically through annual campaigns), their large capital campaign efforts are unique and tend to occur infrequently.
The full process — from determining the amount of the campaign to gathering each individual pledge — can last between one and three years. The pledges are then typically collected over a five-year period, which means the organization should have a financial plan in place if the project will be completed at the beginning of that schedule. If the campaign is needed in its entirety to help pay for the project, one option for a nonprofit to consider is a larger loan that can be utilized for a shorter term.
As interest rates have remained near historical lows, now is still a good time for nonprofits to consider long-term loans. This may be an especially attractive option for nonprofits when you consider that their tax-exempt status also offers special advantages, such as tax-exempt fixed rate loans for up to 30 years. For example, a bank may allow the 501(c)3 to prepay the loan for up to 20 percent per year at par, and at 100 percent for the remaining debt in year five. Banks may also provide variable rate loan solutions, depending on the structure of the transaction and desire of the institution, to create the optimal financing template for each issuer.
Still, any type of bank loan carries risk. Case in point: In the mid-2000s, many nonprofits relied mainly on loans for capital projects while continuing to run operating deficits, only to be faced during the Great Recession with a perfect storm of waning revenue sources and tighter lending requirements that seriously hobbled their efforts.
In addition, before seeking long-term financing for capital projects, nonprofits should prepare for lenders to do due diligence in advance, looking at their organization holistically – from history and reputation to financial expertise and market position as these aspects tell much about a nonprofit’s ability to raise capital and how successful it will be. The stronger these metrics are the greater chances that the nonprofit will be successful in its capital campaign and project completion.
Bankers will typically prepare questions to understand how the nonprofit will manage the specific project as well as its overall operations. Among them: Who is your management and board members? What is their business acumen? What is your market strategy? What is your reputation in the field you’re operating in?
Before seeking funding for any major project, take a holistic look at your organization, from your financial expertise to the competition in your field. Determine where your strengths are, and where your metrics could be improved. No matter what financial strategy path your organization chooses, understanding these considerations can help you craft the strategy that best fits your unique situation.