Beating The Death Spiral

For obvious reasons, many managers have been looking more carefully at end-of-life matters for nonprofits. It is done not out of morbid speculation but because the lessons of history can offer insights into how struggling organizations can avoid the long downward spiral to bankruptcy or dissolution.

This knowledge should be helpful to many organizations during the next two years as the recession finishes working its way through the nonprofit sector (see "What to Expect," The NonProfit Times, January 1, 2009).

As Leo Tolstoy famously observed, "happy families are all alike; every unhappy family is unhappy in its own way." To upend and mangle his thought, consider: "Successful nonprofits succeed in their own way; every failing nonprofit fails in the same way." What is the way every failing nonprofit finally fails? It runs out of money. This is a duh-level revelation, of course. But it turns out that there is more to the story. In fact, it is a multi-part, instructive story.

When you look at the historic financial information from a handful of well-publicized bankruptcies or dissolutions, it is clear that a reliable indicator of decline is the total amount of cash plus investments. The latter are probably a key factor in the group coping psychology of a declining nonprofit. Having an investment portfolio is the holy grail of fundraising, so an organization that has one, no matter how modest, feels more secure in its ability to cope with the future. You’ll see in a moment how that works.

Three patterns

It appears that nonprofits that go out of business tend to be in decline for a long time — financial crashes happen in slow motion. In a small, in-depth study, the handful of organizations showed a marked pattern of financial decline in the cash-and-investments indicator during at least six or seven years. This is significant because it suggests that failing organizations have plenty of warning. Why don’t they do something? That will be explored in a moment, too.

Since it is crucial to have adequate cash to meet payroll, pay expenses, and to be able to cope with unexpected developments, organizations with chronically declining cash and some level of investments will at some point realize they have to sell those investments to have adequate cash. The investments are likely in stocks, bonds, and some small amount of cash equivalents, so it is easy to liquidate them.

While declining organizations typically show a long, slow, steady decline over multiple years, two of the groups studied actually rebounded more than once, meaning that they found another way to increase their cash balances. Short of bringing in a major grant — whose cash impact will disappear as soon as the grant-funded program finishes — the quickest way to boost cash holdings is to sell tangible assets, like a building.

These patterns are the financial ones. But, there is a much more important human story to be told that lies behind the bloodless numbers — the commonplace tale of a declining organization and the reactions and behaviors of its leaders. Piecing this story together requires both observations and relying on the numbers to try to answer the questions outsiders ask after a collapse. Why didn’t they see the danger signs? Why didn’t they act? In trying to answer these questions you need to keep focus on the two key groups of leaders, the board and the executive staff.

The first answer to this question lies in the slow nature of most nonprofit collapses. Rather than making it easier to spot trouble and then respond, a six-or-seven year time span actually makes it more difficult. Most people are comfortable dealing with the here-and-now, the past, or the immediate future. At the beginning of the death spiral, the danger signs can be dismissed. It goes like this: "The six figure deficit last year was a fluke and won’t happen again this year . . . The six figure deficits of the last two years were awful, but we’re only losing five figures this year. Things are getting better."

Executives always have the incentive, and probably the personal inclinations, to view things positively or else they wouldn’t be in their jobs, but, what about the board members? They, too, might share the same positive instincts, plus they often expect their roles to be time-limited so this shapes their time horizon.

Moreover, it’s human nature not to want to warn of disasters all the time, so they might decide to pick their battles. Further along, the board member who sized up the situation early and feels growing concern that’s not shared by their peers could eventually grow weary of the fight and leave the board altogether. Term limits could also compromise the institutional memory, so what is screamingly obvious in year six might be accepted as the status quo by a new group of board members. And, there is the old standby, "we’re just a nonprofit" (meaning "what else do you expect?").

Look at the story from the point of view of the board member or executive who stays with the organization throughout the whole cycle. Sure, that first year or two of deficits were scary, but then the financial investments were cashed in. Why didn’t that trigger a sense of alarm? The probable explanation here, too, is a shortened frame of reference. No matter how it got there, a whopping big balance in the cash account is comforting. Cash is cash, right? How could we be in trouble with all this cash in the bank account?

This is where the brief upticks lull the senses. With a lot of cash and a deficit that might seem to be shrinking, the temptation is to assume that all is well for a few months or a year. But when the underlying deficits don’t change, the chute is greased for a final swift plunge.

Failing nonprofits in the end stage usually reach bankruptcy or dissolution abruptly, in contrast to the long slow slide of the previous years. The end stage scramble is what gives failures the illusion of abruptness to outsiders. What will deliver the final blow? Take your pick: a missed payroll (or two); a missed payroll tax payment; defaulting on a loan payment; a missed workers’ compensation insurance payment (in most states it is illegal to operate without workers’ compensation); a missed payment to a key creditor of some kind (such as a food vendor).

It is important to note that not covered in this column is the underlying reasons for the decline, but just the financial and behavioral signs. The real drivers of disaster could be widely varied and need to be understood and acted on. This is the real message of the financial indicators. The most important way to beat the death spiral is to be aware of it and to act on it sooner rather than later. The accompanying table offers a quick summary of what to look for if you are concerned that your nonprofit is in some part of the death spiral.

The death spiral will likely claim many nonprofits in the coming months. If so, the economic downturn will usually be only the most recent among several causes. The sector is filled with streetsmart managers, but they need time to work. Lack of knowledge about financial indicators — or denial of them — should not be what prevents them from working their magic. The earlier a nonprofit’s leaders understand and accept the seriousness of their situation, the more likely it is that they will find a solution. NPT

Thomas A. McLaughlin is director of consulting services, Nonprofit Finance Fund, and a member of the faculty at the Heller School for Social Policy and Management at Brandeis University. His email address is tom.mclaughlin@nffusa.org