Solving Insolvency

September 17, 2014       Thomas McLaughlin      

There was a recent early summer morning meeting in the offices of a medium-sized nonprofit behavioral health organization in an economically depressed former industrial city. The top three executives were smart, committed, and energetic. The offices were well-situated in a rebounding part of the city, and the organization enjoyed a good reputation locally.

The only thing to mar the occasion was the financial black cloud hanging over the management team’s heads. The nonprofit was insolvent, meaning it was effectively bankrupt but no bankruptcy court had been asked to give it that label.

The organization’s public cost report described the problem. Medicaid funded the largest of its several programs. It had been bleeding money for many years. Every one of the other programs turned at least a small profit. This worked for a while but eventually the cumulative amount of those profitable programs was not enough to cancel out the Medicaid program’s loss.

The result was that in each of the past several years the behavioral health organization had seen its net assets dwindle until the last few years when they began to have “negative net assets,” and the organization was therefore insolvent.

 

The Origin of the Problem

This is a common problem. Often it occurs when an organization begins with a successful major program that over time for whatever reason begins losing money. As it turns out, Medicaid is a frequent cause of this scenario. Because Medicaid is an entitlement, the federal government can’t control its spending on the program’s beneficiaries. It can control its reimbursement to providers, which is what it has been doing for a long time now. The Affordable Care Act might worsen this situation so there could be additional insolvencies like the one described above.

Of course, structural money-losing programs are not limited to Medicaid-funded nonprofits. It happened at a museum when its major exhibit began to seem old and tired to a new generation of visitors. Their turnaround began when the organization started to pay more attention to the content of the main exhibit than just the fiscal results it generated.

 

Solutions

The obvious solution with a money-losing program is to increase revenue, reduce expenses, or both. This is obvious, of course, but it is not always possible. In fact, the Medicaid situation described above is becoming a pattern for some nonprofits founded in the 1970s and 1980s where management has been accustomed to the security of a large, adequately funded main program. The impact of deteriorating economics for that main program is amplified when a decades-old program model changes. When that happens, the smaller programs get squeezed.

Another solution is simply to accept declining economics. In the YMCA movement, for example, there is a tacit understanding that certain clubs located in difficult-to-serve areas will often lose money. These programs are called “mission Ys,” meaning that they are sustained because they fit the mission of the Y movement so fully. In a best-case situation, a mission Y is offset by the success of other Ys in the same system with more favorable economics.

 

Other Sources of Value

It might seem ironic, but money-losing programs can be accepted because they carry out a function that would otherwise not exist, or that might be carried out poorly by any another program. One of these common functions is what we call the Front Door Strategy. Programs that operate as a front door to other programs of the organization can provide a great deal of intangible value even while they lose cash.

Marketing is usually the way organizations get new consumers, and marketing costs money. A successful Front Door Strategy by a money-losing program might be better than stand-alone marketing because at least the program is bringing in some revenue.

A money-losing program occasionally will have a public identity of its own and be much beloved in the community. For example, there’s a program within a much larger nonprofit whose director was a natural politician. He courted local politicians and eventually was elected to office himself. It was easy to forget that he reported to upper management just like everyone else, because he had so successfully built an external reputation for himself and his program that the identity of the larger corporation in some cases was eclipsed.

Another obvious solution is to increase — or begin — fundraising. Older programs are often the biggest money losers. They should have a strong enough brand name to begin at least a minimal fundraising effort. The trouble is that the programs most likely to be money losers are often inextricably attached to low-income communities, which makes fund­raising particularly challenging.

 

Grow more programs

Adding profitable programs is another obvious offset to money-losing programs. For a variety of reasons most parts of the nonprofit sector today are either not growing or are growing only in limited ways.

 

Collaborations

What has been described here is a problem of economics, not finance. Financial systems produce what is thought of as profitable or unprofitable programs. Economics almost always are behind those financial results. When the largest program an organization runs loses substantial money, the economic effect on the rest of the nonprofit is virtually unavoidable. The solution is usually not financial (spend less) but economics (change the underlying economic drivers).

This is one of the situations that prompt nonprofits to collaborate with one or more compatible organizations, usually in a way that changes the corporate structures of each. There is a widespread assumption that the key variable in any corporate collaboration is financial management choices, but the real driver in many of these situations is the economics of one or both entities.

For instance, the insolvent entity might seek as a partner a similar organization that has one or more profitable programs equal to or larger than its own. This would offset their weaknesses without requiring unrealistic expense reductions in their existing programming. (It is often easier to generate profits in a larger organization since there can be more opportunities for boosting revenue or avoiding expenses). Alternatively, the group might be able to join a much larger entity to reduce administrative expenses sufficiently to offset the operating deficit.

It could be helpful to think of one’s collection of programs and services as a portfolio. In any portfolio, there will be stars and there will be slugs. Take that as a given. Streetsmart managers must figure out ahead of time the services that will fall in which category, and then need to stay on top of those services throughout the fiscal year. Remember that financial results are like scorecards. They tell a story, but only partially. Drive your economics. Don’t let them drive you. NPT

Thomas A. McLaughlin is the founder of the nonprofit-oriented consulting firm McLaughlin & Associates and a faculty member at the Heller School for Social Policy and Management at Brandeis University. He is the author of “Streetsmart ‘Financial Basics,” published by Wiley. His email address is tamclaughlin@comcast.net