Is The Way We Think About Charity Dead Wrong? Some Legal Thoughts


Unequal Pay

Dan Pallotta blew the roof off at TED 2013 with his talk about why The Way We Think About Charity is Dead Wrong (over 850,000 views and counting). Dan spoke passionately about the inability of the nonprofit sector to solve some of the society's greatest problems (e.g., poverty has been stuck at 12% for the last 40 years) and how our thinking of charities is preventing the sector from doing more. The problem, he explained, is that we have a different set of rules for charities that puts them at a competitive disadvantage in 5 areas (which I embellish upon):

  1. Compensation – Because of the stark, mutually exclusive choice offered to prospective leaders between doing very well for yourself and your family and doing good for the world, the nonprofit sector is not able to attract or keep the best talent.
  2. Advertising and marketing – Because nonprofits are punished for advertising or marketing like for-profits, the nonprofit sector has not been able to increase its market share relative to the for-profit sector with respect to GDP (charitable giving has been stuck at 2% of GDP for 40 years).
  3. Taking risk on new revenue ideas – Because of the public relations nightmare that would result from an innovative but unsuccessful fundraising endeavor, nonprofits cannot implement daring new ideas needed to exponentially grow the necessary revenues to tackle the big social problems.
  4. Time – Because the public and funders have little patience for nonprofits that fail to immediately, effectively and efficiently create a measurable social impact (unlike for-profit startups that are allowed by their investors to take years to return a profit), nonprofits are forced to adopt conservative strategies that do not allow them to patiently invest in building scale.
  5. Profit to attract risk capital – Because nonprofits cannot promise profits to investors in order to attract capital to fund new and innovative ideas, nonprofits are starved for growth and risk and idea capital.

Dan summarized:

Well, you put those five things together — you can't use money to lure talent away from the for-profit sector, you can't advertise on anywhere near the scale the for-profit sector does for new customers, you can't take the kinds of risks in pursuit of those customers that the for-profit sector takes, you don't have the same amount of time to find them as the for-profit sector, and you don't have a stock market with which to fund any of this, even if you could do it in the first place, and you've just put the nonprofit sector at an extreme disadvantage to the for-profit sector on every level.

If we have any doubts about the effects of this separate rule book, this statistic is sobering: From 1970 to 2009, the number of nonprofits that really grew, that crossed the $50 million annual revenue barrier, is 144. In the same time, the number of for-profits that crossed it is 46,136. So we're dealing with social problems that are massive in scale, and our organizations can't generate any scale. All of the scale goes to Coca-Cola and Burger King.

What Laws Create the Uneven Playing Field?

Certainly much of the uneven playing field is created by public attitudes and expectations, as Dan explains is captured by the dangerous question: "What percentage of my donation goes to the cause versus overhead?" 

  1. Compensation - 501(c)(3) organizations are limited to paying fair and reasonable compensation to any employee or contractor. To pay more may be a violation of the laws prohibiting private inurement and private benefit and could result in revocation of the organization's tax-exempt status. Excessive pay by a public charity may also be considered an excess benefit transaction that could result in penalty taxes against a disqualified person (insider) receiving the excessive amount (which excess must also be returned) and possible penalties against board members who knowingly approved such transaction. These laws help prevent charitable organizations from being used to improperly benefit their founders, directors and officers when such persons are not returning equal value to their organizations. But they also limit the compensation a charity can pay to someone who has the potential to bring in much more value to the organization in terms of social impact than a person willing to accept the limited compensation that the charity can offer. Would charities make a greater net impact if they could risk whatever they wanted or would the abuses create public distrust and weaken the sector overall? I don't think that's an easy question to answer.
  2. Advertising and marketing - 501(c)(3) organizations are certainly allowed to advertise and market, but as Dan says, the public doesn't like to see its donations spent on advertising (especially for a fundraising campaign). If a for-profit spends 90 cents to make $1, it may be a perfectly acceptable profit margin, but if a charity spends 90 cents to make $1, it would be widely viewed as a terrible waste. As a result, many charities fail to properly report their fundraising expenses, and the IRS has raised the possibility of utilizing the controversial commensurate test, which addresses whether a charity is using its resource in line with its charitable mission. The underlying (and, for me, understandable) concern is whether the charity is operating primarily to benefit a company advertising the charity's fundraising efforts (recipient of the 90 cents) ahead of its mission (recipient of the remaining 10 cents). But this can't be judged strictly on percentages, and charities should be allowed to experiment so if an honest fundraising and mission awareness-raising campaign fails, the charity isn't slaughtered for it. The problem, however, is not the law, but the misguided public ideology of which Dan spoke.
  3. Taking risk on new revenue ideas - Board members of 501(c)(3) nonprofit corporations have fiduciary duties, including a duty of care in investing charitable assets. State laws may impose more specific requirements. For example, California law explicitly states the the board must "avoid speculation, looking ahead to the permanent disposition of the funds, considering the probable income, as well as the probable safety of the corporation's capital." It is generally thought that such limitation applies to investments as a whole (based on portfolio theory), but some charity officials don't believe that is the case. So, boards could potentially be in breach of their duties for making one investment that a charity official believes is too speculative (because aren't all investments speculative). Still, the law does serve as a warning to boards that might otherwise abdicate their duties and put all their trust in one investment company or hedge fund without adequate due diligence, understanding or oversight (we all still remember Mr. Madoff).
  4. Time - The charitable sector certainly needs donors, funders, partners, and other supporters with patience (and tolerance for smart attempts that fail). Social problems like poverty, illiteracy, and global warming cannot be solved to scale without patient capital and other resources. But wise profit-motivated investors know to bet only what they can afford to lose. Similarly, wise social investors know to bet only what they believe to be worth giving up. Charities must earn and keep the trust of these investors. Fortunately, this  has been done before with major social change movements led by charities and their leaders. But we need new social change champions. And while patience may be a virtue, in some cases, charities themselves may be too patient, settling for treating symptoms instead of addressing causes. Advocacy (including lobbying) is a powerful, but sadly underutlized, tool for charities to effect change. 
  5. Profit to attract risk capital - 501(c)(3) organizations do not have equity owners that can receive distribution of profits. However, they are eligible to receive program-related investments (PRIs) from private foundations and up-to-fair market rate loans from individuals and for-profits. In addition, 501(c)(3) organizations can participate in joint ventures with individuals and for-profits, though the rules are complicated and, generally, the nonprofit must retain the power to appoint at least half the governing body and to control the charitable program of the joint venture. This may compromise the ability of a nonprofit to attract pure profit-motivated investors/partners, but there is much room for growth in transactions with social investors. Only a tiny portion of private foundation distributions are in the form of PRIs and outside of health care, education, and low-income housing, nonprofit joint ventures with for-profits are rare. Even small changes in the law could encourage more risk capital offering perhaps more modest financial returns than possible with for-profit investments but potentially large social returns. L3Cs may not be a panacea but they've stimulated necessary discussion. Let's also see how social impact bonds fare.

Dan's message resonates with so many nonprofit leaders operating from a perspective of scarcity. And with his closing talk at TED, he goes beyond preaching to the choir. But analyzing the costs, and not just the benefits, of shifting the paradigm; examining the issues from beyond a fundraising angle; and creating ways to change the public's views are difficult discussions we need to keep having.

I love this section of Dan's closing thoughts:

Our generation does not want its epitaph to read, "We kept charity overhead low." We want it to read that we changed the world, and that part of the way we did that was by changing the way we think about these things. So the next time you're looking at a charity, don't ask about the rate of their overhead. Ask about the scale of their dreams …