Individual donors, foundations, and boards often push nonprofits to diversify their revenue streams, but is this doing more harm than good? In this latest blog post, we review research to understand the advantages and disadvantages of diversification and ultimately provide a framework for evaluating whether it’s the right move for your organization.
Want a free and editable copy of our Risk- and Reward-based Framework Matrix? Subscribe 👉 and we’ll send the document to your inbox!
Where is this coming from?
The other week, we were reading this thought provoking and entertaining blog post by the infamous Vu Le of NonprofitAF (yes, that’s really the name… we can’t make this stuff up).
Side note: he’s honestly one of the best nonprofit bloggers out there, so make sure to subscribe to his blog if you haven’t already (non-disclaimer: we wish we were paid for this promotion but, alas, we are not).
In his post, he articulates quite clearly how many nonprofit organizations feel. Individual donors, foundations, and boards do pressure nonprofit management and development teams to diversify, diversify, diversify revenue. He also points out some significant issues with this pressure, including (listed verbatim):
- It forces nonprofits to spend time, energy, and money on ineffective strategies;
- It punishes organizations led by and serving racialized and marginalized communities;
- It distracts [nonprofits] from challenging the fundamental awfulness of the nonprofit funding system;
- It lets funders off the hook so they can continue doing ineffective stuff; and
- It reinforces the toxic idea of nonprofits as “dependents” of funders.
We couldn’t agree with these points more. He is absolutely right in everything he posted. The system is biased, antiquated, and unfair. However, he never says that organizations should not diversify their revenue. Instead, he concludes with:
“Nonprofits, do what works best for you and the communities you serve. If you’re great at getting grants, then focus on that. If you’re doing well cultivating individual donors and want to stick with that, that’s fine too… And if you have interest and resources to explore other streams of funding at the same time, go ahead and experiment. But don’t “diversify” when it makes no sense to do so. And if you’re achieving outcomes for your community, don’t feel bad or be apologetic if your revenues lean heavily one way or another.”
Yessss! *clap*clap*clap* Again, we couldn’t agree more. Nonprofits have to do what is best for them with their reality of limited resources, capacity, and time.
Something was gnawing at us. As accounting, finance, and data nerds with 2 MBAs between us, something felt off. If well diversified revenue is considered to be the gold standard by individual donors, foundations, and boards, that ‘conventional wisdom’ must come from somewhere right? Even Michael and myself, who have served on boards and have advised many nonprofits ourselves, have given this very advice. Then it hit us — have we been giving advice that was causing more harm than good? Enter our existential crisis.
Seriously, though, Vu’s challenger blog raised questions for us that needed answers. Let’s take a look at what we discovered.
What does the research say?
To our surprise, we found that there has actually been a significant body of research done on this very topic over the past 30-ish years. What’s even more surprising is that the research is not overwhelming in favor of diversification.
A lengthy meta-analysis of the research published in 2018 by Arizona State University professors ChiaKo Hung and Mark A. Hager concluded in a very anticlimactic two sentences:
“…result indicates a statistically significant positive overall relationship between revenue diversification and nonprofit financial health. However, the magnitude of the relationship is relatively small, a statistically significant association that may not be substantial enough to guide practical decision making.”
We literally read through God only knows how many pages of their analysis to be completely blindsided by this conclusion. I’m sure you’re feeling the same way with this blog post. You’ve made it this far in and you probably are pulling your hair out because we haven’t actually told you anything. Stick with us. We’re getting there, we promise!
Their meta-analysis was not all for naught, however. In it, they reviewed the research that supported various arguments for and against diversification. Below is a summary of the research:
- Flexibility. Greater diversification provides greater flexibility to adapt to idiosyncratic changes (i.e. unhappy donor) or environmental events (i.e. global pandemic, financial crisis, etc.).
- Autonomy. Organizations with multiple funding sources have more autonomy in how they work with their communities because they are not entirely controlled or constrained by one or a few donors or grantmakers.
- Potential. If your organization can find additional revenue, you will be able to increase your impact.
- Exposure. As you find more and more funding sources, your organization builds brand reputation in your community and increases its profile. In the long run, this increases your “survival probability” by creating brand recognition.
- Unknowns. Additional revenue streams come with additional, often new and unknown, risks to the organization. Further, research has shown that nonprofit managers usually lack the information required to properly evaluate risks to maximize the advantage of new revenue streams.
- Overhead. With new revenue sources, comes more complexity and resources required to develop, track, monitor, evaluate, and report. In fact, research supports that organizations with only one revenue stream are more “administratively efficient” than nonprofits with two or more. The analysis does note that overhead is not necessarily bad, but many donors do tend to believe the ‘overhead myth’.
- Complacency. Research has shown that psychology can harm the ability for nonprofits to diversify revenue. If a donor base sees an organization as adequately supported by significant and long-term government funding, they are less likely to give individually. Essentially, asking an organization to diversify with individual donor revenue can be an exercise in futility.
- Mission Drift. Asking organizations to diversify their revenue can create mission drift. In an effort to satisfy donor and governing body expectations, management may shift their programs to meet donor expectations instead of their community’s needs.
Revenue diversification, in the short term, has its benefits. However, in the long run, the benefits can be diluted by many factors, many of which are unknown and misunderstood.
So what the heck are you supposed to do with this knowledge?
Great question. Our goal as a company is not only to give you information, it is to either inspire action or support inaction. We want you to be able to see data differently and use that data to become a better, more intentional organization. (shameless plug: check out our cool dashboard that does just that with your financials!).
Theoretically, as this masochistic academic theorized, in order to “provide a certain level of services (a given level of expected return) while minimizing unpredictable changes in revenues (risk)” all you have to do is calculate variances of individual revenue sources and the covariance between the sources. Sounds easy, right? Here’s the simple, easy-to-use formula that will allow you to do that:
I’m sorry, but does that not inspire you? Are you sure? Not even a little bit?
If you haven’t run away already, that was 96% a joke. While you could theoretically apply this model to your organization, it is 99.99999999% likely that you won’t.
Since the research basically indicates that the answer to the question of “should you diversify your revenue?” boils down to the very lawyer-y answer of “it depends”, we figured we’d try to piece together a framework to inspire deeper thought on this topic.
Diversification should be intentional and risk-/reward-based.
Too often, as we now know, organizations are pushed to diversify their revenue simply because it’s considered to be conventional wisdom. Unfortunately, conventional wisdom is not always right. Instead of diversifying for diversification’s sake, take a step back and ask yourself whether it makes sense to go down this path. Take time to analyze and understand the short- and long-term implications of what it will actually take to make this shift.
We’d like to offer a framework for your evaluation, which is based on a random assortment of articles we found somewhere on the internet last year. We’re unfortunately serious about this — we don’t remember how we found these resources, but we continue to use them because they are extremely useful! Our suggested framework is based on risk and reward, which we have chosen to define as the multiplying effect of the “likelihood” that something will happen and the magnitude of its “impact”. Risk is negative impact and reward is positive impact. Below are visuals of the frameworks with a sample scoring system.
The above framework suggestion is just an example. You can create your own score ranges based on your unique organizational needs (i.e. 1 to 10 instead of 1 to 5, etc.), but creating a quantitative way to evaluate whether it makes sense to diversify revenue will provide you a better sense of your opportunities (if any truly exist). Once you have your reward / risk framework, you can then use this framework to compare the risks and rewards of the cumulative advantages and disadvantages of any type of revenue diversification you have in mind. The result might fit into something simple like this:
We tied the framework back to the meta-analysis mentioned above and created a matrix. With this framework matrix, you can evaluate the option of diversifying revenue against the four advantages and four disadvantages, indicate the likelihood, and calculate the potential magnitude of impact. Once you have all inputs in the matrix under the likelihood and impact columns, you can multiply to get individual reward and risk scores. You then can total all of the reward and risk scores to see if the risks potentially outweigh the rewards. Our framework matrix also includes the option of prioritizing certain advantages and disadvantages by assigning weights (or priorities, whichever you choose) to each of the items. This will allow you to further understand the true effects of risks and rewards for your nonprofit organization.
The last thing we’d like to suggest is that you should not assign values lightly. You should very carefully consider why you are assigning certain values to the “likelihood” and “impact”. When in doubt, increase the likelihood and magnitude of impact of the disadvantages while decreasing the likelihood and magnitude of impact of the advantages. Set you nonprofit up for success by being realistic. As the body of research indicates, diversifying can harm your organization. Take your time making this decision and in completing this framework matrix. Be intentional, garner broad support, and if you do decide to diversify, go hard to make it work!
If you are a nonprofit funder or board member, our recommendation is simple: heed Vu’s advice and listen to your organization.
While you might be right in the short-term, that doesn’t mean you are right in the long-term. Gently encourage your organization’s management team to evaluate the opportunities in diversification. Michael and I certainly have a renewed outlook on this topic; you have to be intentional in your evaluation and be willing to approach your nonprofit’s leaders from a place of empathy.