Endowments are a great tool for nonprofits to use and potentially fall back on during periods of economic uncertainty. And while endowments are associated less with meeting short-term needs and more with long-term growth and stability, even smaller nonprofits can benefit from creating them.
Next Steps After Establishing an Endowment
What is an Endowment?
An endowment is a term that is often associated with higher education, established foundations, and large nonprofits. They’re actually much more accessible than many small nonprofit leaders may realize. Endowments, are typically comprised of donor funds that are invested in the stock market, are established to fund a specific purpose.
There are three types of endowments: permanent, quasi-, and term. Permanent endowments can either be restricted or unrestricted for specific use purposes. Permanent endowments are usually held in perpetuity and funds are either spent according to a specific purpose (restricted) or not (unrestricted). Quasi-endowments are meant for a specific purpose and are board-designated, not donor-restricted. The earnings are available to fund programs or other expenses, and the organization maintains the principal balance. Term endowments can be used after a set period of time or after a certain triggering event.
And they can start with small amounts of money; a term endowment can be created with just an initial gift of $75, for example. $200 can fund a permanent endowment. Any funds can be designated to an endowment, even without a specific donor. If the funds are accounted for properly, there is the potential to create an endowment. Although the initial gift can start small, there are costs to oversee and manage the endowments.
Benefits of an Endowment
They offer continuous income that grows over time as the endowment’s investment funds also grow. In turn, the organization gets a steady, growing revenue stream for years to come.
Average annual returns for endowments vary based on the stock market; during the pandemic, average annual returns for college endowments were less than two percent in 2020 but about 30 percent in 2021. Even smaller endowments averaged more than 20 percent.
Diversifying income sources is one clear advantage. Managing resources is another. While the endowment is established for a specific purpose, the income it generates can be redirected back into the organization. This frees up other resources that would have otherwise been used on operations, fundraising, and more.
And while the funds in an endowment continue to grow over time, the income can be a consistent part of ongoing budgeting. Once a donor establishes an endowment, it’s often easier to attract other long-term financial gifts and donations and regular, year-round donations.
Endowment Considerations for Smaller Nonprofits
The problem for smaller nonprofits is that they may feel endowments are out of reach. When the primary concern is staying open for another three years and funding this year’s programs, how valuable can a long-term endowment really be? Organization must also follow the requirements of the Uniform Prudent Management of Institutional Funds Act (UPMIFA). This is a legal requirement and consultation with appropriate legal counsel is recommended.
Instead, nonprofit leaders can adjust their frame of reference. Yes, smaller nonprofits can establish endowments. Yes, it is worth the time and expense. It’s a mindset shift to begin to plan for programs and initiatives many years from now. Instead of managing for expenses, nonprofit leaders manage for income. It’s a historical versus future-based approach that creating an endowment helps to cultivate.
How to Create an Endowment
As with any other financial planning guidance, there is no one-size-fits-all approach; however, these steps will point nonprofit leaders in the right direction.
To the last point above, organizations first need to adopt more sustainable financial management practices. There are four questions to guide implementation:
- How is organizational income categorized?
- It’s more than operational expenses; there are asset-based donations that can lower expenses. And there’s the intangible impact of goodwill and reputation to consider. These and other factors can help leaders to pinpoint a better budgeting and spending strategy.
- Is income raised after setting expenses?
- Instead, try to match projected expenses with realistic income plans, rather than raise money that’s already been allocated.
- Are spending percentages realistic?
- Benchmarks for labor, fundraising, and operational costs should generally match industry standards and enable the organization to support its mission.
- Is there a cash reserve, and if so, what is its status?
- An emergency savings fund is critical for periods of economic uncertainty. COVID certainly imparted that lesson, and nonprofit leaders would be wise to remember it.
Once a more holistic financial management approach is understood, the next step is to get the Board of Directors and/or donors on board with the idea of an endowment. The endowment is still in the exploratory stage and part of that due diligence process is collaborating with internal and external stakeholders. Transparency is key.
At this stage, getting the Board used to the idea of maintaining a strong cash reserve is important. But some Board members may need convincing. Though this excerpt was written in 2011, maintaining an adequate cash reserve is still just as important as ever.
“CASH = OXYGEN. Cash buys you time to think, is insurance against funding cutbacks, lets you sleep at night assured you can make rent at the beginning of the month. Cash lets you manage rather than just survive.
And growth? Growth is funded by cash.”
At this next stage, as the nonprofit’s cash position and financial management has improved, it’s time to focus on getting the highest possible ratings on Charity Navigator. The Working Capital Ratio is a key metric. Working capital measures how long the organization could survive on just its liquid assets. A higher working capital ratio tells current and potential donors that the nonprofit manages its cash well. If the organization can meet its programming goals without annual grant money, it sends a more positive message that the organization is focused on the long-term.
Next Steps After Establishing an Endowment
Once an endowment or cash reserve is established, promote it! Include it in capital campaigns and ongoing fundraising efforts. Showing that donations can fund future progress and growth is a different conversation than one in which donations fund only this year’s goals.
Managing an endowment requires yearly maintenance and written financial policies. A CPA can help to implement these policies and guide nonprofit leaders toward sound financial management.
It’s important to work with an external advisor to help manage the cash reserve and endowment, especially if the account balances are in the thousands of dollars. When it comes to financial managers, look for CPAs and RIAs – registered investment advisors. Both designations mean that these individuals are well-versed in finances, tax, and money management. Perhaps more importantly, they’re ethically required to act only in the best interests of their clients.
Endowments are well within the reach of small and midsize nonprofit organizations. It starts with a basic understanding of the organization’s goals and then a deeper dive into where the nonprofit wants to be in the future.
For questions about endowments and nonprofit financial management, contact PBMares Partner Jonny Rosch, CPA in our Not-for-Profit practice.
