Building vs. Buying: Distinguishing Capital and Revenue for Nonprofits

Capital and revenue are as different, and important, in the nonprofit space as in the for-profit space, but these differences are often overlooked—endangering the health and sustainability of nonprofit enterprises and the missions they serve.

apples oranges 829422 pxhere com

In the for-profit world, it’s easy to differentiate capital and revenue. Revenue (a.k.a. “sales”) is the money a company collects from its customers in exchange for goods and services. Capital is money provided by investors and lenders—or retained through profits—to build and expand a business.

In the nonprofit world, we frequently conflate the two, in part because there is no such thing as equity ownership for nonprofits (note: we focus in this piece on grant capital; loans are not conflated in the same way). However, nonprofits are still enterprises and must be built and run as such, or risk ceasing to operate well or at all. This means that for nonprofits, the difference between capital and revenue is most clearly seen in how the money is spent. In a seminal piece, George Overholser, then at the Nonprofit Finance Fund (NFF), encapsulated the difference, saying that capital is spent to build the enterprise, and revenue is used to pay for operations, products and services:

Building the Enterprise … requires growth capital and close stewardship. It requires a patient process of trial and error. It is highly technical and has a high risk of failure. More often than not, it requires major shifts in strategic direction, and major shifts in personnel. Also, it is an episodic thing – once an enterprise is built, the builders can go on to other projects. Indeed, it is precisely by dismantling their growth capital “scaffolding” that they prove they have built an enterprise that can stand on its own.

Buying from the Enterprise … [is] about “what work will be done in exchange for my money?” It isn’t about changing what the enterprise does; it’s about asking the enterprise to do more of what it already knows how to do. So it’s not about risk, or about shifts in strategy.

To be clear, revenue is absolutely necessary. Without it, capital is wasted. Purchasers of nonprofit goods and serviceswhether government, private 3rd party fee-for-service payors, or direct fee payers on one hand, or providers of grants and contributions on the otherare essential to the nonprofit ecosystem. Reliable ones are its lifeblood.

Distinguishing Capital and Revenue is Essential for Long-Term Impact

When a for-profit obtains capital from an equity investment, it may spend the cash on one-time investments in property, equipment, and systems. It may also spend that money on what are effectively ordinary operating expenses such as salaries, rent for expanded space, etc. But the managers of the company are clear that the investment dollars used to cover operating costs are temporary and they must achieve reliable revenue to cover those annual expenses before the capital runs out. That clarity comes primarily from how the dollars are accounted for. Equity goes directly onto the balance sheet. It never flows through the profit and loss statement. Companies often show losses during periods of growth when they use equity (and debt) to pay their bills. Nonprofit accounting—and the deep discomfort with seeing deficits even when they are planned—makes it much harder.

The damage of conflating capital and revenue is a genuine danger to nonprofits and those they serve. As Rodney Christopher and Rebecca Thomas explain in another NFF publication, “When capital and revenue are conflated, an organization’s reports show an overly optimistic picture of operating health.” This rosy view can lead funders to hold back or restrict funding, ultimately damaging the enterprise’s operating health and leading to anemic impact or even the demise of the organization. They offer a potential reporting treatment that aims to help nonprofits and their funders distinguish capital from revenue.

In the ‘Looking-Glass World’ of Nonprofit Finance Capital Still Matters

The difficulty in distinguishing capital and revenue for nonprofit enterprises does not diminish the need to do so. As Clara Miller notes in “The Looking-Glass World of Nonprofit Money,” even though many pillars of for-profit financial management are confusingly false for nonprofits, “investment in infrastructure during growth is necessary for efficiency and profitability” for all enterprises, both nonprofit and for-profit. In addition, profitability (or surpluses) are essential for the health, sustainability, and impact of the organization.

At Heron, a key part of our grantmaking practice is driven by this need. Enterprise Capital Grants are explicitly intended as capital, to be invested into the nonprofit enterprise according to a business plan. That plan articulates how the organization aims to grow or change in a particular set of ways, intended to result in a stronger enterprise that is better able to achieve its mission and, unequivocally, to attract revenue in the future. Other typical types of grant capital include money for facility projects and endowments. Occasionally nonprofits will receive grants to seed or expand reserves. Most rare is capital for restructuring, e.g., paying off liabilities, usually provided alongside growth/change capital to ensure a healthy enterprise post restructuring.

How the Looking-Glass Confuses on Capital

If capital is so important, why is it so easily conflated with revenue in the nonprofit context? One reason is that virtually all non-debt money comes to nonprofits as grants or donations, which are treated the same from an accounting perspective. Because by definition (according to their IRS tax status) nonprofits cannot have owners, the accounting standards for nonprofits do not easily account for money that comes from “owners” versus money that comes from “customers.” (This is compounded by the fact that many nonprofits provide services to one group of “customers,” such as housing for homeless clients, that are paid for by other “customers,” or donors.)

Part of the reason donors may hesitate to term their grants “revenue” is to avoid the implication that they will continue providing similar grants every year forever—while the term “capital” attractively suggests that the money is “one and done,” providing funders with more flexibility to direct future grants elsewhere. In addition, sometimes a grant or contribution is legitimately a combination of capital and revenue, depending on how it is intended to be spent. We urge both funders and nonprofit managers to acknowledge the necessity of both capital and revenue and to strive for clarity in differentiating between the two—for the health of nonprofits and their long-term ability to achieve the impact we all seek.

Leave a Reply

Your email address will not be published. Required fields are marked *